Short-Term Funding Market Under Strain: Calls for Fed Intervention Grow
The $12 trillion short-term funding market, a critical financial artery that pumps daily cash into Wall Street's veins, is experiencing heightened turbulence. Pressures are steadily mounting, prompting a growing chorus of institutions to call for a more robust response from the Federal Reserve (Fed) to address liquidity crunches.
Warnings from Bank of America, Sumitomo Mitsui Nikko Securities, and Barclays
Prominent institutions such as Bank of America, Sumitomo Mitsui Nikko Securities, and Barclays have cautioned that the Fed may need to take action. This could involve increasing lending in short-term money markets or even directly purchasing securities to inject cash into the banking system and ease pressures that are pushing overnight interest rates higher.
Concerns About Fed's Response
"Given the market pressures we've seen recently, it appears the Fed is simply making incremental adjustments to its balance sheet policy," stated Gennadiy Goldberg, head of US rates strategy at TD Securities. He added, "Some investors feel the Fed may be moving too slowly to prevent reserve shortages."
Spiking Short-Term Interest Rates
Recent weeks have witnessed a notable increase in a range of key short-term interest rates. This includes benchmark rates tied to overnight repurchase agreements (loans secured by government bonds) and the Fed's own key policy interest rates – which typically remain stable during interest rate decisions but have risen four times within their target range in the past two months.
Significant Volatility in SOFR
The Secured Overnight Financing Rate (SOFR) has even experienced its largest single-day swing outside of a Fed rate-hike cycle since March 2020, when the COVID-19 pandemic was at its peak.
Causes of Liquidity Pressures
The underlying causes of the liquidity pressures include a surge in US Treasury issuance, which siphons substantial amounts of cash from short-term money markets, reducing available funds for the banking system. The recently ended government shutdown exacerbated this situation by delaying federal spending that could have boosted liquidity. In addition, ongoing quantitative tightening (QT), or balance sheet reduction by the Fed, has contributed to the trend.
Tapering QT Still Not Enough
Despite the Fed's recent announcement that it intends to halt the reduction of its Treasury holdings starting December 1st, market pressures have not abated. Some fear that the end of the government shutdown stalemate will not fully resolve the issue.
Signals from Fed Officials
Roberto Perli, the New York Fed official in charge of the securities portfolio, indicated on Wednesday that recent increases in funding costs suggest that the banking system's reserves are no longer abundant and that the Fed "won't have to wait long" to start buying assets. These remarks echoed similar statements made by policymakers in recent days.
Potential Implications for Financial Markets
For market participants, this signal is welcome. The core stakes relate to the smooth functioning of key financial market mechanisms -- where cash-rich institutions like money market funds lend short-term funds and investors like hedge funds borrow using high-quality assets like US Treasuries as collateral to fund popular strategies like basis trades.
Concerns About Market Volatility
The concerns about liquidity shortages raise the prospect of market volatility, undermining the Fed's ability to control interest rates, and in extreme cases, forcing investors to unwind positions, which could impact the US Treasury market, the global benchmark for borrowing costs - at a time when the economy is still facing uncertainty.
Memories of 2019
For many market veterans, memories of September 2019 remain vivid. At that time, a key overnight interest rate spiked to 10%, forcing the Fed to intervene and inject $500 billion into the financial system.
Lending Support Tools Help
So far, the funding market is still functioning relatively smoothly. Lending support tools the Fed has put in place in recent years (such as the standing repo facility, or SRF, that allows eligible institutions to borrow money using Treasuries and agency debt as collateral) have helped to contain sharp increases in repo rates. The tool has been used frequently in recent weeks.
Caution in Balance Sheet Reduction
Policymakers have also maintained caution during balance sheet reduction - this April, the Fed slowed the pace of QT due to Congressional wrangling over the debt ceiling, noting that the rebuilding of the Treasury's cash balance could put additional pressure on reserve levels.
Current Situation Considered a "Contained Signal"
"You could argue that the 2019 situation was a bit of a disaster," said Zachary Griffiths, head of US investment grade bond and macro strategy at CreditSights Inc. He added, "What we've seen more recently in funding markets is more of a contained signal that reserves have basically gotten down to a level that's appropriate for stopping QT."
Potential Easing of Pressures Ahead
While the market widely expects that pressures will ease in the coming weeks as the Treasury plans to reduce the size of weekly Treasury auctions and dormant cash from the Fed is released after the government shutdown ends, there are risks of year-end volatility. Banks typically reduce their activity in the repo market ahead of year-end to meet regulatory requirements and improve their balance sheets, a behavior that could exacerbate year-end funding market turmoil.
Views of Fed Officials
Cleveland Fed President Beth Hammack stated last week that as reserves continue to move toward an "ample" level (the latest data shows current reserves at $2.85 trillion), officials are trying to determine an acceptable range for volatility.
Healthy Volatility
"I think seeing some volatility in front-end rates is a good thing, as long as they remain within our policy range," Hammack said at the Economic Club of New York. She added, "Like, 25 basis points of volatility, I think, is healthy."
Potential Need for Asset Purchases
However, Dallas Fed President Lorie Logan, who worked for many years in the New York Fed's markets division, stated last month that if repo rates continue to rise, the Fed will need to buy assets, adding that the size and timing of the purchases should not be mechanical.
Frustration with Lack of Clear Guidance
For some market participants, the disagreement among policymakers about the appropriate range for money market operations, and the overall lack of clear guidance, is frustrating.
What is Effective Control of the Money Market?
"Where do you want the average level of money market rates to be? What is effective control of the money market?" said Mark Cabana, head of US rates strategy at Bank of America. He added, "In our view, expecting repo rates to self-correct is unlikely to get to the outcome the Fed hopes for."
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