(Bloomberg) — US funding markets, which have been awash with easily accessible and cheap cash for nearly two decades, appear to be entering a new phase of higher borrowing costs posing a worry for investors and policymakers.
Interest rates on ultra-short-term financing used by banks and asset managers to borrow and lend to each other have been steadily rising as the Treasury is rebuilding its cash pile just as the Federal Reserve is tightening its own balance sheet. Meanwhile, usage of one of the Fed’s overnight lending facilities — long considered a measure of excess liquidity in funding markets — has dropped to a four-year low.
If liquidity keeps drying up and borrowing costs continue to mount, as many on Wall Street bet, that spells more volatility in markets and even raises the risk of a sudden skyrocketing of overnight money market rates as happened six years ago.
“We are seeing a level shift in funding and it is consistent with a different funding paradigm where money funds no longer have excess cash to deploy to the RRP,” said Mark Cabana, head of US interest rate strategy at Bank of America Corp, referring to the Fed’s overnight reverse repurchase agreement facility.
While he doesn’t believe in a repeat of the September 2019 episode — dubbed by some the “repocalypse” — he does see higher overnight financing rates taking hold. In a sign that’s already happening, overnight rates climbed well above the Fed’s own target rate at the beginning of September and have remained elevated since then.
Against this backdrop, traders are girding themselves for a possible shortage of funding as soon as next week when a combination of auction settlements and corporate tax payments threaten to drain more money out of the system. A sudden drop in liquidity could disrupt the balance of cash and assets used as collateral by banks and others in short-term transactions, just as the amount of funds they hold with the Fed as a cushion has been dropping.
A flurry of Treasury bill issuance after the government raised the debt ceiling earlier this summer is luring away cash, dragging yields higher across a range of instruments. Interest-rate benchmarks tied to overnight repurchase agreements collateralized by US Treasuries are hovering around the Fed’s interest on reserve balances rate, an indication that the market may be struggling to digest the glut of issuance.
Since the beginning of September, the gap between repo and the federal funds rate has grown to about 11.5 basis points on average, the widest level since the end of April. That spread was in single digits in July and August as market participants were able to digest supply by shifting allocations to T-bills from repo.
Stubbornly elevated funding costs is new territory for a market that has grown accustomed to steady rates since the 2008 financial crisis. Over time, they affect access to cheap short-term funding for everyone as they get passed on to businesses and individuals, reducing the benefits of interest-rate cuts by the Fed.
In a note outlining the risks of a rapid shift higher in repo rates, Cabana and strategist Katie Craig warned that banks may become unwilling or unable to lend short-term funds while the effects could spill over to the $29 trillion US Treasuries market if they upend popular relative-value trades used by hedge funds to benefit from price gaps between cash bonds and derivatives.
For the Fed, persistently high overnight rates pose a number of challenges, including how much longer it can continue unwinding its balance sheet — a process known as quantitative tightening that’s been underway since June 2022 and is expected to conclude by the end of the year. They can also affect the amount of reserves banks choose to hold with the Fed without causing ructions — a level that is known as ample — and test liquidity backstops that have been put in place to prevent such tumult.
“The funding markets give us a real time read,” said Wells Fargo strategist Angelo Manolatos. “The longer we consistently set near IORB, the Fed participants are more likely to think we are close to the lowest comfortable level of reserves.”
Bank reserve balances are currently around $3.15 trillion, according to the latest Fed data, with Fed Governor Christopher Waller recently estimating ample at $2.7 trillion.
Roberto Perli, manager of the Fed’s massive portfolio of securities, said in May that the central bank’s tools for controlling short-term interest rates will become increasingly important, noting the more frictionless the facility is, the more effective it will be.
To ensure the repo market continues to function during periods of volatility, the Fed has introduced Standing Repo Facility — which allows eligible institutions to borrow cash in exchange for Treasury and agency debt at a rate in line with the top of its policy target range, currently 4.5%. Usage of the tool spiked at the end of June to the the biggest since it was made permanent in July 2021.
The Fed’s backstop is a key reason investors are less anxious this time about a repeat of the September 2019 blowup. Back then, reserves became scare as the Fed was again trimming its portfolio, driving repo rates to double digits and forcing the central bank to pump half a trillion dollars into the market.
“We do not view the recent backup in SOFR as reflective of an imminent funding event,” strategists at JPMorgan Chase and Co. led by Teresa Ho, wrote in a note to clients Thursday, noting though that the SRF “has yet to be tested.”
“To the extent SRF is efficient in controlling money market rates and providing a ceiling on repo, an earlier end to QT might not be needed,” they wrote.
Still, any volatility in the second half of September could stir a debate around QT. A handful of officials, including Waller and Dallas Fed President Lorie Logan, have acknowledged rising pressures in money markets but stopped short of suggesting an early end to the balance sheet runoff.
That’s reinforcing views that as the Treasury ramps up bill issuance again in October, higher funding costs are here to stay.
“We’re not going back unless the Fed does something to add liquidity permanently,” Cabana said. The question is “what is the magnitude and speed of the move in the next step up.”
More stories like this are available on bloomberg.com
