By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) -The Federal Reserve’s decision on Wednesday to begin winding down its long-running balance sheet runoff has done little to ease concerns about near-term liquidity strains in the roughly $4 trillion U.S. overnight repurchase market.
U.S. repo futures continue to reflect expectations of elevated overnight funding rates over the next two months, despite the U.S. central bank’s announcement that it will reinvest all proceeds from its maturing mortgage-backed securities (MBS) into Treasury bills. Analysts estimate the reinvestment will amount to $15 billion in T-bill purchases per month.
In halting the drawdown of its still-sizable balance sheet, the Fed cited signs of tightening liquidity that have driven repo rates higher over the past few months.
Since launching quantitative tightening, or QT, in June 2022 to unwind emergency stimulus measures introduced during the COVID-19 pandemic, the Fed has slashed the size of its balance sheet from a peak of roughly $9 trillion to about $6.6 trillion.
The Fed’s increased demand for Treasury bills is expected to significantly shrink their net supply to private investors in 2026, likely driving prices higher and yields lower. This dynamic could help alleviate supply pressures and stabilize overnight funding rates.
Still, the initial reaction in the futures market pointed to expectations of a higher Secured Overnight Financing Rate (SOFR) – an overnight repo rate – in November and December, relative to the effective federal funds rate, the central bank’s key policy rate. The fed funds rate reflects the cost of unsecured overnight loans between banks used to meet reserve requirements.
“The key takeaway here is that the Fed is not alarmed by recent front-end developments, and does not see a need for any dramatic adjustments in its operations,” said Lou Crandall, chief economist at money market research firm Wrightson ICAP.
SOFR stood at 4.27% on Thursday, while the effective fed funds rate, reported with a one-day lag, was 4.12% late on Wednesday.
The one-month SOFR-fed funds futures spread is a key liquidity stress indicator: the more negative it is, the tighter repo funding conditions are perceived to be.
Following the Fed’s policy decision this week, that spread hit minus 11.5 basis points (bps) for the November contract, a record gap. For December, the spread dropped to minus 12.5 bps, also an all-time low.
The numbers suggested that investors in the futures market expect SOFR to trade 11.5 bps and 12.5 bps higher, respectively, than the fed funds rate by the end of November and December.
FED COULD HAVE DONE MORE
“The market was largely priced in for an announcement on the end of QT, and we got that, but we didn’t get anything that was out of left field for dovish risks,” said Jan Nevruzi, U.S. rates strategist at TD Securities in New York.
“The Fed ended QT with a month delay, so that doesn’t really help for November. We also didn’t get anything that was a surprise on the upside: they could have said … that they’re also thinking about reserve management purchases, which could have meant another $20, $30 billion a month in reinvestments.”
Repo rates are also currently elevated due to the end of the month on Friday, which also happens to be the end of the year for Canadian banks, making funding tight for a non-quarter reporting period like October. Analysts said Canadian banks are lenders in the U.S. repo market.
Overnight rates tend to spike at the end of the month, quarter or year, as primary dealers, mostly large banks, withdraw from acting as middlemen in repo transactions due to higher balance sheet costs that make them look bloated during those reporting dates.
Pressures in repo markets are also largely due to aggressive bill issuance by the Treasury to build its cash balance after the U.S. debt ceiling was lifted over the summer. The increased bill issuance has raised the need for repo financing to absorb all those Treasuries in the market.
“I don’t think QT would have had much of an immediate effect on repo rates whether you ended it or not,” said Joseph Abate, head of rates strategy at SMBC Nikko Securities in New York.
Yet the Fed’s planned reinvestment of MBS proceeds into T-bills was not a surprise.
Dallas Fed President Lorie Logan, who previously ran the New York Fed’s open market operation, had suggested in a speech in February this year that the central bank’s portfolio of Treasuries was significantly overweight longer-term securities and underweight short-dated bills. She noted that moving toward a more neutral mix would mean holding relatively more bills.
T-bills are currently just less than 5% of the Fed’s Treasury holdings.
“A bill-heavier portfolio can do more maturity transformation trades where you replace the bills as they run off with longer-dated securities which bring down term rates,” SMBC’s Abate said.
An increase in bill holdings enhances the Fed’s operational flexibility and helps minimize the portfolio’s unintended influence on market rates beyond its QT objectives, he added.
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Paul Simao)
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