Investors on alert for ructions in US funding market

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Investors are on alert for a potential end-of-year increase in US overnight lending rates, with some calling for the Federal Reserve to slow the pace at which it shrinks its balance sheet to avoid the kind of liquidity crunch that hit funding markets five years ago.

Analysts and executives at several banks and asset managers told the Financial Times they were monitoring strains in short-term funding rates after an unexpected jump at the end of the third quarter.

The repo or repurchase market plays a critical role as a benchmark for broader US lending rates by setting a rate for investors to borrow cash overnight, in exchange for high-quality collateral such as US Treasuries.

The late September move raised fears that the amount of bank reserves in the system, an important source of liquidity for the market, may not be as plentiful as market participants had expected.

“I’m certainly more worried than I was last year-end,” said Gennadiy Goldberg, head of US rates strategy at TD Securities. While such concerns are an annual feature, there was “quite a bit more” liquidity available at the end of last year, he added.

Over the course of a couple of days in September, the secured overnight financing rate, or Sofr, which closely tracks the US central bank policy rate, spiked 0.2 percentage points to 5.05 per cent. Analysts at Bank of America estimated it to be the biggest spike, relative to Fed rates, since the Covid-19 sell-off in early 2020 and pointed the finger in part at a “cash drain” from the system at the end of the quarter.

Rather than lending, banks were holding on to their cash to maintain the reserve levels mandated by regulators, analysts said.

The tremors have been enough to awaken memories of 2019 when the market was jolted by a large surge in overnight rates. The spread between the repo rate and policy rate soared to more than 30 times its normal size. Only after the Fed said it would buy $60bn of Treasury bills a month did rates stabilise and return to previous levels.

Bank reserves are “not scarce [but] we’re not in full abundance”, Goldberg said, noting that the move in September this year “rang an alarm bell”.

Analysts point out that the shortage of cash is in part the consequence of the end of the Fed’s policy of quantitative easing. The central bank’s balance sheet bloated to a peak of almost $9tn after the Covid pandemic, flooding the system with cash by buying trillions of dollars of Treasuries. As the Fed allows its balance sheet to roll off as bonds mature, the level of bank reserves in the system is falling.

Overnight rates often surge at the end of the quarter — and particularly at the end of the year — as banks reduce their lending activity to control their balance sheets for financial reporting purposes.

“Regulators 1734442137 have a lot more eyes on the different money market rates, and market participants are also attuned to any dislocations,” said Akshay Singal, global head of short-term interest rates trading at Citigroup.

The Fed has introduced various measures since the 2019 episode to stave off a repeat, including a standing repo facility to push against any excessive funding pressures that build up.

In October, the New York Fed, which is responsible for implementing monetary policy, unveiled a new gauge for US banks’ reserves and said they “remain abundant”. Last month, Roberto Perli, a top official at the New York Fed, said that quarter-end pressures “do not appear to be induced by a scarcity of reserves”.

Still, the Fed has already slowed down the pace of its balance sheet shrinkage, known as quantitative tightening. In May, it announced it would lower the monthly cap on the maturing Treasuries it allowed to roll off, from $60bn to $25bn.

The market ructions five years ago forced the Fed to pause a similar exercise to unwind its balance sheet.

While conditions in money markets are easier today than in 2019, “similar dynamics” to those that brought a halt to quantitative tightening were present, said Goldman Sachs in a note earlier this month. It expected the Fed to “slow the pace” of its balance sheet shrinkage. 

Mark Cabana, head of US rates strategy at Bank of America, said he was expecting a jump in Sofr at year-end and had “broader concerns about the possibility of additional funding stress that would be more material next year if the Fed does indeed continue QT for too long”.

A challenge for next year, according to investors, is the debt ceiling, a cap on US government borrowing that will be reinstated on January 2. At that point, the Treasury will start bringing down its cash balance, rather than issue more short-term debt, thus pushing up banks’ reserves. 

That mechanism could present an unduly healthy picture of longer-term liquidity, say experts. The Fed could “lose the signal that money markets provide when the debt limit constrains the size of the Treasury cash balance”, said BofA’s Cabana.

“If they [then] just rely on money market indicators, that runs the risk that they drain too much liquidity out of the system,” he said.