The Fed is on guard for funding pressures as QT ends

The funding markets have gotten some attention lately, but the Federal Reserve seems to have learned from the past.

At its October Federal Open Market Committee (FOMC) meeting, the Fed announced it would cease attempting to shrink its balance sheet (known as quantitative tightening, or QT) on December 1 — earlier than many had originally forecast. Then last week, Roberto Perli, the System Open Market Account manager at the New York Fed, said in a speech that it won’t be long before the Fed starts to purchase assets again to maintain desired reserve levels. 

What is this all about? The Secured Overnight Financing Rate (SOFR) has the answer. In recent weeks, this index of repo transactions collateralized by US Treasury securities frequently averaged above the interest rate the Fed pays on reserves, currently 3.90%; occasionally, it has also traded above the upper bound of the fed funds target range, currently 4%.

The hints of funding pressures have brought back unpleasant memories of September 2019, the last time the Fed was shrinking its balance sheet. In response to a confluence of events, reserve levels unexpectedly dropped, causing repo rates to leap hundreds of basis points during one trading session. To its credit, the Fed stepped in quickly with sizeable reserve injections to normalize market conditions.

We believe circumstances are very different now.

For one, the upward pressure stems from well-understood reasons, including:

• QT taking Fed reserves from “abundant” to closer to what would be considered “ample,” in the Fed’s words.
• Robust Treasury bill supply in the third and fourth quarters have given money market funds more attractive investment alternatives than leaving excess cash at the New York Fed Reverse Repo Facility, taking its balance to low levels.
• The US Treasury’s operating cash balance has been high. It hit $1 trillion in late October and has hovered above $900 billion since, though it is expected to decline moderately in upcoming weeks.

Second, the Fed is on guard. It is shooting for a higher relative level of reserves than it did in 2019. And it has created the Standing Repo Facility (SRF), to allow for a more proportional provision of reserves relative to injections of the past. If overnight rates climb too far, eligible banks and dealers can borrow cash through the SRF in exchange for high-quality collateral. In the most recent episode when rates pushed past 4%, the SRF saw modest usage, albeit less than could have been expected. Ways to shore up the SRF inefficiencies are being analyzed by the Fed, with ideas under consideration including central clearing of SRF transactions, a topic that was featured in the recently released minutes to the October FOMC meeting.

From the perspective of money market funds, where repo positions provide liquidity as well as a foundation for portfolio structure, we have not been troubled by the recent relatively high repo rates. It is not an issue of credit or liquidity stress in the markets, but rather a practical manifestation of the Fed’s balance sheet management. Ending QT in December will help, as will improving the effectiveness of the SRF and maintaining a robust level of reserves going forward.