Fed's Reverse Repo Usage Drops Amid Renewed Financial System Stress
The Federal Reserve's Reverse Repo facility usage has decreased by $220 billion in the past two days, reflecting a decline in demand similar to the stress observed in December, rather than previous quarter-ends. However, this decrease is less pronounced than the $313 billion drop at the end of 2023, indicating that banks are holding onto liquidity more tightly than usual.
On social media, we noted:
"It's concerning that banks are in such urgent need to improve their financial statements."
Further concerns arise as a crucial financial system stress indicator shows signs of strain. The Secured Overnight Financing Rate (SOFR), a key rate for daily borrowing needs, spiked to a record high of 5.40% on July 1, driven by large Treasury auction settlements and constrained lending capacity due to primary dealer balance sheets being overloaded.
Despite the Federal Reserve's ongoing quantitative tightening (although at a slower pace as they taper QT), underlying financial system volatility is resurfacing, reminiscent of last year's stress. This was particularly evident during the recent quarter-end funding period, where banks reduced repo activity to strengthen balance sheets for regulatory reasons, forcing borrowers to find alternatives or pay higher rates.
Additionally, an increase in government debt sales requires more collateral financing from the repo market, leading to higher costs.
"This might be the new normal and explains why the Fed reduced the cap on runoffs," commented Subadra Rajappa, head of US rates strategy at Societe Generale SA. "With record coupon issuance sizes and high primary dealer holdings, balance-sheet constraints are likely. This situation feels similar to year-end, and it may take a few days for the repo market to stabilize."
Although the recent SOFR spread spike is not as extreme as the COVID-related stress in March 2020 or the repo crisis in September 2019, it is trending in a concerning direction. Bloomberg notes that indicators of financial strain seen in 2018-2019, such as near-record dealer holdings of Treasuries and rising overnight repo rates, have re-emerged.
The Fed's Standing Repo Facility has managed to cap repo rates, but questions remain about its effectiveness during stress periods. Small banks, facing reserve constraints, may have to rely on the Discount Window if the situation worsens, which could lead to the de-stigmatization of this facility in Federal Reserve communications.
The Fed might need to consider cutting rates or reverting to quantitative easing (QE), but given President Biden's declining poll numbers, such a move could appear politically motivated.
"Stopping QT could help stabilize the situation, but it might not significantly improve conditions," said Gennadiy Goldberg, head of US interest rate strategy at TD Securities. "The rising cost of cash is a result of moving from extreme liquidity to a more normal environment."
Despite these concerns, some experts remain optimistic:
"This might be the new normal and explains why the Fed reduced the cap on runoffs," reiterated Subadra Rajappa. "With record coupon issuance sizes and high primary dealer holdings, balance-sheet constraints are likely. This situation feels similar to year-end, and it may take a few days for the repo market to stabilize."
For now, we will closely monitor reverse repo usage and the SOFR spread for further signs of financial system stress.