By Michael S. Derby
WASHINGTON (Reuters) -Federal Reserve interest rate-control liquidity facilities are set for a heavy-duty workout into the close of the month, with big implications for how much farther the U.S. central bank can take its balance sheet wind-down process.
The Fed’s reserve repo facility and its still largely untested Standing Repo Facility (SRF) are likely to see major inflows as banks and other firms navigate normal month- and quarter-end volatility, in an environment where central bank balance sheet reductions have been slowly but persistently drying up liquidity.
Wrightson ICAP analysts reckon the reverse repo facility could surge from its current negligible usage to as high as $275 billion at the end of this month. But more notably, the SRF, launched in 2021 as a tool to ensure fast liquidity by converting Treasuries into cash, could see genuine inflows after a couple of quarter ends that saw modest action.
The research firm has “penciled in’ around $50 billion into the SRF on September 30, a level well above the $11 billion seen on June 30, the last trading day of the second quarter.
CONTROL OF FED’S SHORT-TERM INTEREST RATE TARGET
Accurately gauging market liquidity at the end of a quarter is always tricky because the factors that constrain the flow of money are transient and driven in large part by market participants adjusting activity for reporting and other activities, which they in turn quickly reverse once the new quarter begins. There also have been large swings in the Treasury Department’s account at the Fed, which weigh on financial sector liquidity.
How the Fed’s tools perform is critical to the Fed’s ability to maintain control of its short-term interest rate target, which directly flows from what it is doing with its large holdings of cash, bonds and other assets.
The Fed is expected to raise its benchmark interest rate by a quarter of a percentage point at the conclusion of its two-day policy meeting on Wednesday. The policy statement and updated quarterly economic projections will be released at 2 p.m. EDT (1800 GMT), with Fed Chair Jerome Powell holding a press conference about half an hour later.
Since 2022 the Fed has been reducing the size of its holdings after more than doubling its balance sheet to about $9 trillion during the COVID-19 pandemic, as part of an effort to normalize financial market liquidity. Markets see the quantitative tightening (QT) process running into early next year, but many acknowledge it could stop sooner.
The Fed accepts and expects there to be volatility in money markets and reckons its tools will work to smooth that over, granting QT more runway
“We have more room to reduce reserves” via QT, Dallas Fed President Lorie Logan said last month. “We could see some temporary pressure” through September, but active usage of the SRF in particular “will allow us to continue gradually bringing reserves to a more efficient level.”
Financial market reserves currently stand at $3.2 trillion and have been fairly steady for a while as QT has largely worked to extinguish excess liquidity parked at the reverse repo facility. That process is largely done, so reserves should fall more quickly now. In a speech over the summer, Fed Governor Christopher Waller said $2.7 trillion in reserves could be the endgame for QT.
MOUNTING PRESSURE IN REPO MARKETS
The SRF looms large in Fed thinking because it has been positioned as an automatic shock absorber, in turn reducing pressure on the Fed to actively manage liquidity swings and allow QT, which is designed to remove reserves from the financial system, to continue to run.
“The Fed needs to have automatic tools that can address pressures in funding markets when they occasionally occur,” said Patricia Zobel, head of macroeconomic research and market strategy at Guggenheim Investments and a former manager of the New York Fed team that implements monetary policy. “I don’t think periodic or occasional disturbances in money markets mean that you’re not at an ample level of reserves, and so there need to be facilities that can help address that,” which is what the SRF does.
Many observers agree that heavy and extended usage of the SRF, especially beyond September’s flashpoints, could be a signal that QT needs to stop.
Mark Cabana, head of U.S. rates strategy at Bank of America Securities, said “the Fed has overdrawn liquidity from the system,” and the repo markets – that’s where banks borrow and lend securities to finance trading positions – are seeing mounting pressure that should only grow over time.
Pressure on repo rates complicates Fed control of short-term interest rates, so it’s a matter of keen interest to policymakers.
Cabana reckons Fed liquidity facilities will get the central bank over the hump into the new quarter, but market pressures in the form of rising repo rates will continue to mount. “This will be a key signal to the Fed they need to stop QT,” which is currently likely at the end of the year, although it could become a front-burner topic at the Fed’s October 28-29 policy meeting, he said.
(Reporting by Michael S. Derby; Editing by Paul Simao)
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