(Bloomberg) - Pressures simmering in the $12 trillion market that serves as a critical source of day-to-day funding on Wall Street are spurring a growing chorus of calls for a more forceful Federal Reserve response to ease the pinch.
Bank of America Corp., SMBC Nikko Securities Inc. and Barclays Plc are among firms warning that the central bank may need to take steps such as lending more in short-term markets or buying securities outright to pump money in the banking system and ease strains that have pushed up overnight interest rates.
“The Fed seems to only gradually be changing balance-sheet policy given recent stresses,” said Gennadiy Goldberg, head of interest rate strategy at TD Securities. “Some investors believe the Fed may be moving too slowly to prevent reserves from becoming scarce.”
A batch of key short-term rates has remained stubbornly elevated in recent weeks, from benchmarks tied to overnight repurchase agreements, or repos — loans collateralized by government debt — to the central bank’s own key policy target, which rarely moves between rate-setting decisions and yet has risen four times within its range over the past two months.
One gauge, the Secured Overnight Financing Rate, even had its biggest one—day move outside of a Fed interest-rate hiking cycle since March 2020, the height of the pandemic.
Driving the squeeze is an increase in Treasury bill issuance, which has siphoned away cash from short-term markets and left less money in the banking system.
The government shutdown, which ended late Wednesday, had exacerbated the situation by delaying federal spending that otherwise would boost liquidity. Meanwhile, the Fed’s ongoing efforts to shrink its balance sheet, known as quantitative tightening, have also played a part.
Strains have persisted even after the Fed recently announced it will stop unwinding its holdings of Treasuries as of Dec. 1, and some are concerned the end of the government impasse won’t completely solve the problem either. Extending the trend, the latest read on rates showed repo-backed benchmarks rising further above the rate paid on bank reserves, or IORB.
Driving the squeeze is an increase in Treasury bill issuance, which has siphoned away cash from short-term markets and left less money in the banking system.
The government shutdown, which ended late Wednesday, had exacerbated the situation by delaying federal spending that otherwise would boost liquidity. Meanwhile, the Fed’s ongoing efforts to shrink its balance sheet, known as quantitative tightening, have also played a part.
Strains have persisted even after the Fed recently announced it will stop unwinding its holdings of Treasuries as of Dec. 1, and some are concerned the end of the government impasse won’t completely solve the problem either. Extending the trend, the latest read on rates showed repo-backed benchmarks rising further above the rate paid on bank reserves, or IORB.
The concern is that a lack of adequate liquidity may spur volatility, undermining the Fed’s ability to control its rate-setting policy and, at the extreme, potentially force position unwinds that could spill into the broader Treasury market, the global benchmark for borrowing costs, at a time when the economic outlook remains uncertain.
For many market veterans, memories of September 2019 are still fresh in their minds. That’s when a spike in a key overnight rate to as high as 10% forced the Fed to intervene by pumping half a trillion dollars into the financial system.
As of now, funding markets are functioning smoothly, and lending backstops put in place by the Fed in recent years have helped keep repo rates contained. One such backstop, the Fed’s Standing Repo Facility — which allows eligible institutions to borrow cash in exchange for Treasury and agency debt — has seen regular use in recent weeks.
Policymakers have also shown caution during the balance-sheet runoff, even slowing the pace in April amid the Congressional wrangling over the debt ceiling, mindful that rebuilding the Treasury’s cash balance could put additional pressure on reserve levels.
“It’s safe to say 2019 was a bit of a disaster,” said Zachary Griffiths, head of US investment grade and macro strategy at CreditSights Inc. “What we’ve observed lately in the funding markets has been more of a controlled signal of reserves having essentially fallen to where it makes sense to stop reducing the size of the balance sheet.”
While pressures are largely expected to dissipate in coming weeks as Treasury anticipates reducing the size of its weekly bill auctions and more cash parked at the Fed will be spent once the government shutdown ends, there’s still the risk of a volatile year-end. That’s when banks typically pare their repo market activity in an effort to shore up balance sheets for regulatory purposes. That dieting tends to occur before December and could exacerbate any year—end disruptions in the funding markets.
Cleveland Fed President Beth Hammack said last week officials are trying to identify what levels of volatility are acceptable as reserves continue to move toward levels considered to be ample —— they’re currently $2.85 trillion, according to the latest data.
“I think it’s good to have some amount of volatility in those front-end rates, as long as they’re staying within our band,” Hammack said at the Economic Club of New York. “So maybe that’s 25 basis points of volatility I think that’s healthy.”
Yet Dallas Fed President Lorie Logan, who spent years earlier in her career on the markets desk at the New York Fed, said last month the central bank would need to buy assets if repo rates stayed elevated, adding that the size and timing of the purchases shouldn’t be mechanical.
For some market participants, the disparate views as to where money markets should trade and overall lack of clarity is frustrating.
“Where do you want money markets on average? What is money market control,” said Mark Cabana, head of US interest rate strategy at Bank of America. “To us, hoping that repo rates self-correct is unlikely to yield the outcome the Fed is hoping for.”
By Alexandra Harris
With assistance from Christopher Condon
