- Key measures of liquidity have begun to tighten
- Heavy treasury issuance and some bank balance sheet issues may have played a role
- The level of reserves in the system may no longer be ample
- The Fed has plenty of tools at its disposal to ease liquidity
- We expect actions imminently
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Commentary: Liquidity watch
Despite a major rate hike cycle and years of steady quantitative tightening, the market for USD liquidity has been stable. Last time things turned disorderly was six years ago, when the Secured Overnight Financing Rate (SOFR), which is the benchmark rate for the US repo market, jumped by 280bps to 5.25% in the span of one day in mid-September 2019. The unexpected tightening of liquidity prompted the Federal Reserve Bank of New York to inject several hundred billion dollars into the repo market that week. The US Federal Reserve also stepped in, lowering interest rates on reserves during the same period.
While dramatic, there was nothing particularly mysterious about the liquidity event—a confluence of factors coming together at the same time, including quarterly corporate tax payment, treasury auction settlement, and the cumulative impact of declining bank reserves as part of the Fed’s reversal of GFC-era liquidity injection, led to the spike in repo rates.
Developments of recent weeks point toward similar dynamic, although nothing as dramatic yet. Measures of market liquidity, including the spread between SOFR and the Effective Fed Funds Rate, as well as the 3-month commercial paper and overnight interest rate swap rate, have begun to rise. Banks have been tapping the Federal Reserve’s Standing Repo Facility (SRF) in ever larger quantities in recent months. Secured funding benchmarks such as the Tri-Party General Collateral Rate (TGCR) have also been rising.
These developments are interesting as the Fed has resumed cutting interest rates and overall financial market conditions have been easy. When reserves are plentiful, small liquidity shocks are absorbed readily with the existing mechanisms in place, but when they begin to get tight, even routine settlement flows can push funding rates up. The US financial system is deep enough that an odd development or two, say the balance sheet deterioration of a regional bank, should not cause consternations in the repo market. Yet, it seems to be not entirely comfortable. Particularly, heavy treasury issuance is not helping matters, in our view. The authorities are bound to have noticed this; some action should be around the corner.
Many tools are available to deal with such eventualities. They include ending of quantitative tightening, and as a last resort, resumption of bond purchases, easing of liquidity coverage rules, and reduction of capital surcharges. The Fed remains keen to maintain ample reserves in the system; we expect it to get to work imminently.
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