Stress in US money markets could flare up again and spur the Federal Reserve to take swifter action to tame another burst higher in short-term interest rates, Wall Street banks have warned.
Short-term funding rates have steadied this week after signs of strain late last month in a vital section of the financial system’s plumbing prompted concern among some bankers and policymakers.
The difference between a key market-based rate known as tri-party repo and one set by the Federal Reserve hit its highest level since 2020 last Friday, despite the central bank saying that it would halt a programme to reduce the size of its balance sheet on December 1.
Tri-party repo rates eased back in line with the Fed’s rate on reserve balances this week, as pressure on money markets waned. But market participants remain worried about the spectre of another jump in repo rates in the coming weeks.
“I don’t think it was a one-off anomaly of just a few days of volatility,” said Deirdre Dunn, head of rates at Wall Street bank Citigroup, who also serves as chair of the Treasury Borrowing Advisory Committee.
Scott Skyrm, executive vice-president at repo market specialist Curvature Securities, added that while markets had “normalised”, partly because banks tapped a Fed facility to release pressure in money markets, “funding pressure is going to be back at least at the next month-end and year-end”.
Samuel Earl, a US rates strategist at Barclays, echoed that sentiment, noting that funding markets were “not out of the woods”.
Some analysts and policymakers say the Fed may need to begin outright purchases of assets if pressure does not abate.
Dallas Fed president Lorie Logan, a former member of the New York Fed’s markets group, noted last week that “if the recent rise in repo rates turns out not to be temporary, the Fed in my view would need to begin buying assets”.
The debate about whether the central bank needs to move to steady funding markets comes as many analysts say that it is on the brink of pulling too much money out of the financial system as a result of three years of quantitative tightening.
When that happens, banks’ levels of reserve cash can dip into perilous territory.
“One could argue that we’re not in an ample reserve environment anymore and these events could continue to happen . . . It would be prudent for the Fed to think about what other tools they have in their back pocket,” Dunn said.
The Fed’s QT programme has happened alongside record Treasury bill sales, reinforcing the liquidity strain. This is because big banks that act as underwriters for the government’s debt soak up issuance that is not purchased by investors. These dealers turn to the repo market to finance these purchases in an effort to avoid tying up their own cash.
“Such aggressive bill issuance is elevated by historic standards and risks exhausting Treasury bill demand from traditional investors,” said Meghan Swiber, a rates strategist at Bank of America.
“To better balance bill supply and demand, we believe a long dormant buyer will likely be needed: the Fed.”
