Money markets flash a warning

In mid-October the Secured Overnight Financing Rate (SOFR) kept printing above the Interest on Reserve Balances (IORB) rate. Money markets rarely send a clearer warning. Bank reserves are no longer plentiful and are getting close to scarce.

The strain has been building since the summer. After Congress raised the debt ceiling in July, the Treasury sold a flood of bills to rebuild its cash balance at the Fed. At first the money came mostly from the Fed's overnight reverse repo facility, where money-market funds had parked spare cash. That buffer is now close to empty, so further drains fall directly on the reserves banks hold at the central bank. The pressure has shown up not only at month- and quarter-ends, when it is expected, but on ordinary days too.

Why SOFR should sit below

When reserves are abundant, the rate the Fed pays on them (IORB) acts as a firm ceiling on secured overnight borrowing rates. If SOFR rises above IORB, commercial banks are holding on to their cash and will not lend the surplus in the repo market. The heavy issuance of Treasury bills after the debt ceiling was raised, together with continuing quantitative tightening, has drained liquidity from primary dealers' balance sheets.

The logic is one of opportunity cost. A bank with spare reserves can leave them at the Fed and earn IORB with no risk, or lend them overnight in the repo market against Treasury collateral. If repo pays more than IORB, a bank with truly surplus reserves should lend and pocket the difference, and that arbitrage normally keeps repo rates below the Fed's rate. When repo stays above IORB for days at a time, it means banks no longer think they hold surplus reserves. They want to keep them for payments, for regulatory liquidity requirements or as a precaution.

The 2019 warning

The Fed has been here before. It stopped shrinking its balance sheet in the summer of 2019, judging reserves to be ample. In mid-September that year a corporate tax deadline and the settlement of a large Treasury auction drained reserves on the same day, and overnight repo rates jumped far above the Fed's target range. The Fed had to lend in the repo market for the first time in a decade and then began buying Treasury bills to rebuild reserves. The episode showed that the level at which reserves turn scarce can only be found by reaching it, and that the transition can be abrupt.

This time the Fed has more tools. Its standing repo facility, set up in 2021, offers overnight loans against Treasuries at a fixed rate and should cap how far repo rates can rise. Use of the facility has picked up this autumn. Banks remain wary of borrowing from it too visibly, however, for fear that markets will read it as a sign of weakness, so the cap is less firm in practice than on paper.

From repo to the wider market

When secured funding rates jump above the Fed's targets, dealers pay a penalty to carry the government bonds they hold in inventory. Left alone, strain in funding markets spreads to corporate commercial paper and to the clearing of Treasury auctions.

The chain of transmission runs through leverage. Hedge funds that hold cash Treasuries against short futures positions, the so-called basis trade, finance their bonds overnight in repo. When repo rates rise, the trade becomes less profitable and some funds cut positions, selling Treasuries into a market already absorbing heavy issuance. Dealers facing higher funding costs bid less aggressively at auctions, and yields on new debt rise. What starts as a technical imbalance in overnight money can therefore raise the government's borrowing costs and make the Treasury market less liquid.

Who pays

Money-market funds and banks with surplus liquidity gain from higher overnight rates. The losers are leveraged investors financing bond positions, dealers carrying inventory, and in the end the Treasury, whose auctions depend on dealers and leveraged buyers to absorb supply. Corporate borrowers in the commercial-paper market may also pay a little more, as investors demand a premium over repo rates that are themselves elevated.

The case against a panic

The strongest argument against alarm is that the Fed has seen this coming and has already signalled a response. Jerome Powell said last week that the Fed could stop shrinking its balance sheet in the coming months, as reserves approach the level officials consider ample. Some of the pressure also reflects temporary factors, including heavy bill settlements and the Treasury's large cash balance, which will ease as that balance is spent down. On that view, the market is simply telling the Fed that the end of quantitative tightening is near, which the Fed already knows.

That is a fair reading, and it is the likeliest outcome. The risk lies in timing. Pressures in funding markets tend to build slowly and then break suddenly around specific dates, such as the end of a month or a large settlement. A Fed that waits for its next scheduled meeting to act may find the market does not wait with it.

Signals to watch

The indicators are the spread between SOFR and IORB on ordinary days, daily use of the standing repo facility, the balance at the reverse repo facility, the Treasury's cash balance and the Fed's decision at its meeting at the end of October. SOFR above IORB is the canary in the coal mine. Short-term liquidity has dried up, and the Fed will probably have to stop shrinking its balance sheet within weeks if it wants to avoid a full-blown repo panic. The likeliest outcome is an announcement at the October meeting that quantitative tightening will end soon, with the month-end in between serving as the next test of how scarce reserves have become.