The US Treasury building in Washington.
(Bloomberg) — A key interest rate for the US financial system jumped to the highest level this year — exceeding the Federal Reserve’s target range for its own benchmark — as dwindling liquidity is exacerbated by Treasury auction settlements and quarterly corporate tax payments this week.
The Secured Overnight Financing Rate — a one-day lending benchmark linked to activity in the market for repurchase agreements — rose to 4.51% as of Sept. 15 from 4.42% the prior session, according to the latest Federal Reserve Bank of New York data published Tuesday. That’s the biggest increase in the fixing since Dec. 31.
Rates on overnight 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 concurrently with the Federal Reserve reducing its 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.
The uptick pushed the spread between SOFR and the effective fed funds rate, which policymakers are expected to cut by a quarter point on Wednesday, to 18 basis points — the widest since Dec. 26. The fed funds rate is as of Sept. 12.
It’s 11 basis points above the rate the Fed pays on reserves parked at the central bank — currently 4.40%.
“Funding market conditions are still very stable,” said Rishi Mishra, an analyst at Futures First Canada Inc. “If anything, we can say there that we are shifting closer to the slightly upward slopes of the reserves demand curve. This would mean larger fixings on all settlement and balance sheet dates.”
Persistently high overnight rates could put into question how much longer the Fed can continue unwinding its balance sheet — a process known as quantitative tightening — without draining essential liquidity from the financial system. Over time, they can also reduce the effectiveness of reductions to the central bank’s target rate, just as the Fed is expected to resume its easing cycle.
WATCH: Bob Michele previews the Fed decision.Source: Bloomberg
The Fed has been winding down its balance sheet since 2022, in a bid to reverse trillions of dollars in asset purchases designed to stimulate the economy after the pandemic shock. In the process, it hopes to bring bank reserves kept at the central bank to a minimum level, considered as ample, which would be sufficient enough to prevent market disruptions.
Officials this year slowed down the pace of balance-sheet reduction as reserves have been approaching that endpoint. Bank reserve balances currently stand at around $3.15 trillion, according to the latest Fed data. Fed Governor Christopher Waller recently estimated the minimum ample level to be around $2.7 trillion.
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Benchmark rates are expected to remain under pressure as the government ramps up Treasury bill issuance after raising the debt ceiling in the summer, draining the Fed’s overnight reverse repurchase agreement facility. On Tuesday, some 16 counterparties parked $18.8 billion at the so-called RRP, up from $17 billion the prior session.
Yet. market participants are expecting a reprieve before volatility picks up again for quarter-end. That’s because two long-dated cash management bills are slated to mature, resulting in a net supply paydown of $50 billion on Tuesday, in addition to the monthly influx of cash from government-sponsored enterprises in the coming days.
“Repo has normalized quickly this morning, which is somewhat encouraging,” said Wells Fargo strategist Angelo Manolatos. “Paydowns over the next two weeks provide some relief to the market before attention shifts to quarter-end.”
(Adds results of Tuesday’s overnight reverse repo operation in 10th paragraph.)
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