The US Federal Reserve is widely expected to cut interest rates at its meeting on Wednesday, leaving little to no room for surprise. The rest of the excitement centers on what the central bank signals about its balance sheet and future direction. Short-term interest rates have been particularly volatile in recent weeks, with the U.S. repo market trading within several basis points of the Fed’s limit and actually rising above the upper end of the range on Monday, suggesting a potential liquidity crunch. The repo market is considered the plumbing of the U.S. financial system, providing short-term collateralized overnight loans to market participants. The rise in funding rates has raised questions about the state of bank reserves, and many analysts are betting that the Fed will end its quantitative tightening (QT) program sooner than expected. “We expect the FOMC to conclude its securities runoff elections at this month’s meeting,” analysts at Wrightson ICAP wrote in a note, noting that recent repo market volatility is “sufficient warning signs to justify moving to the next stage of the Fed’s normalization plan.” The pervasive weight of the repo market has led to continued use of the Fed’s Standing Repo Facility (SRF), which was created after the 2019 repo market explosion as a liquidity backstop and de facto cap on the funding market. In addition to significant negative market perceptions, SRFs suffer from structural issues such as balance sheet costs (which are not centrally cleared), which prevent them from gaining serious uptake from market participants outside of high-pressure closing dates. Banks and dealers have historically been reluctant to use SRFs, even if arbitrage opportunities exist, raising concerns as to why emergency facilities are being used now. Are severe liquidity pressures creating, forcing member institutions to use SRFs as a true last resort? “SRF is working as expected,” said Samuel Earle, Berkeley’s head of short duration strategy. “The Fed has been encouraging people to use[SRFs]when there are frictions in the funding markets.” Barclays expects the Fed to end QT in December, and Earle noted that if the Fed ends QT early due to SRF concerns, the unintended consequences could be to further strengthen the SRF stigma that central banks have worked hard to eliminate. Dallas Fed President Laurie Logan said earlier this year that she expects banks to rely on SRFs in the second half of the year as liquidity pressures from September tax day, quarter-end and high issuance weigh on the market. “We were encouraged to see market participants utilizing SRF at the end of the June quarter,” Logan said in late August. “I think in September, they’ll be using our ceiling tools as well, if they want.” What if using SRF isn’t an issue? “This is really just an issuance thing,” Earle said. “Issuance is putting pressure on repo rates. This is not a lack of reserves issue.” Since the July debt ceiling resolution, cash has been flowing out of the repo market as the Treasury restructures its main checking account. The Treasury has issued nearly $600 billion in Treasury bills so far, and Barclays expects another $200 billion in net issuance this month. The abundance of Treasury bills provides an attractive alternative to money market funds, the primary source of liquidity in the repo market, and increases bargaining power with repo dealers. The impact of dwindling cash in money markets and the ever-increasing demand for leverage from hedge funds has pushed the overall short-term interest rate complex higher, making marginal dollars increasingly difficult to find. “We’ve gone from a system of deep reserves where a lot of collateral was put into the system and was digested relatively easily, to a system where even small amounts of collateral can have a huge impact on the repo market,” said Teresa Ho, head of U.S. short-term strategy at JPMorgan. Essentially, the repo market has become dramatically more sensitive to the injection of additional collateral, which is likely to be a concern for the Fed as it battles political pressure from the White House, Ho warns. JPMorgan now expects the Fed to end QT at today’s meeting, citing concerns about widespread pressure on funding markets. “The current funding pressures cannot be explained by normal factors such as settlements and closing dates, and it is worrying that they are occurring on a regular basis,” Ho added. Last week, the collateralized overnight funding rate (SOFR) came within an average of 5 basis points of the SRF offering rate of 4.25, raising liquidity concerns across the fixed income community as surplus funds from government-sponsored enterprises (GSEs) typically lower repo rates. “It was even heavier during the GSE period,” Ho said. “That, to me, was a sign that we were no longer in a state of abundant reserves.” Last week, bank reserves fell below $3 trillion, the lowest level since the first week of January, shining a bright light on an already contentious debate over the appropriate level of reserves. Read more The Fed is likely to keep cutting rates, but there are multiple dangers, CNBC poll says Ray Dalio says a risky AI market bubble is forming but may not burst until the Fed tightens The Fed is expected to cut rates – how to secure a return on your savings now The discussion for ending QT today is primarily one of risk management: marginal dollar cost, collateral sensitivity, year-end Canada, GSIB, etc., year-end with continued liquidity concerns heading into the fourth quarter. Meanwhile, the Fed faces increased scrutiny from President Donald Trump’s administration, and JPMorgan suspects Fed Chairman Jerome Powell is less willing to risk funding market stress. Together, these factors could outweigh the benefits of continuing the program, which has only $40 billion in funding left between now and December. “The bigger question for me is what to do after the QT,” Ho said. “The budget deficit is only going to widen, Treasury issuance is increasing, and the amount of collateral in the system is only increasing.”Current trends suggest a decline in demand for U.S. Treasuries from the traditional big buyers: banks, the Federal Reserve and foreign central banks, with Deutsche Bank saying its holdings of U.S. Treasuries recently hit a 13-year low. As a result, the role of leveraged players who ultimately have to fund these new Treasury positions in the repo market has expanded, increasing the demand side of the equation just as repo liquidity and reserves are becoming scarce.
