Wall Street is getting worried that the Federal Reserve's aggressive efforts to control short-term borrowing rates have run into some potholes, with more danger ahead. The central bank has been working feverishly to address issues that popped up more than a month ago in the repo market, the overnight lending place where banks go to borrow money from each other. A cash crunch led to a spike in several rates, leading the Fed to institute programs to maintain proper liquidity levels. While the effort has worked fairly well so far — rates rose last week, though not nearly as much as in mid-September — finance professionals fear that the market problems are not fixed and funding issues can happen again.

"The repo market has been drugged into submission by the Fed," said Jim Bianco, head of Bianco Research. "That's fine for a while. But what I am getting concerned about is that they're not figuring a way to get it off the drug and get it back to normal, and that will be a problem longer term for them." Investors have long complained about the Fed hand-holding the market, injecting trillions of dollars in liquidity and keeping interest rates artificially low during and after the financial crisis. This is a different situation, though. Rather than looking to goose the economy back to health, the Fed is now using its balance sheet to make sure banks have enough reserves and an adequate amount of capital is flowing through the system to keep things running efficiently. The effort also is aimed at keeping the Fed's own overnight funds rate within the 25 basis point target range it employs.

Likely 'to get worse ... before it gets better'

To do so, the central bank earlier this month announced a new bond-buying program that initially will target about $60 billion a month of short-term Treasury bills. The program began last week with about $20 billion worth of purchases. As the balance sheet expansion kicked off, the funds rate pushed to the upper end of its target range, hitting 1.9% for a few days, or 10 basis points above the interest on excess bank reserves, which is supposed to serve as a guardrail for the funds rate. The repo rate similarly rose, eclipsing 2% at one point. Market pros worry that a confluence of factors will make the Fed's market balancing act difficult. Bianco insists that the Fed is not being discerning enough about credit quality in providing cash in exchange for collateral; others are concerned with what happens as the year draws to a close and banks are more focused on shoring up their liquidity mandates than keeping cash flowing in the overnight markets. "With year-end coming up, this is all likely to get much worse, in our view, before it gets better," J.P. Morgan Chase fixed income analysts led by Joshua Younger said in a note. Younger pointed to last week's rate bump as indications that all is not settled in the repo markets. The Fed has said that large settlements of Treasury auctions were at the root of September's disturbance — along with payment of corporate income taxes — that sapped money out of the system. But Younger said such events, rather than serving as excuses, "look much more like warnings." "Given the benefits of our newfound perspective, we recommend viewing these moves as highlighting the limitations of the Fed's chosen solution to their operational issues," he wrote. In addition to buying T-bills, the Fed has been conducting a series of temporary operations to keep the overnight markets humming.

The balance sheet is 'a much bigger deal'