With the easing of volatility in the overnight financing market at the end of the year, Wall Street is refocusing on how long the Federal Reserve can continue to reduce its balance sheet without causing more serious interference?
Traders are beginning to carefully observe the funds in the Federal Reserve's so-called Overnight Reverse Repurchase Agreement (RRP) mechanism. On Tuesday, only about 78 counterparties deposited $704.9 billion in the Federal Reserve's reverse repurchase facility, a decrease of $313.6 billion from the previous trading day (December 31), making it the third largest daily outflow since the mechanism was launched in 2013 (all at the beginning of the year).
In the past few months, these counterparties (mainly money market mutual funds) have been withdrawing funds from the mechanism to take advantage of higher returns elsewhere, and as the amount of funds used by the mechanism gradually approaches zero, the volatility of the repurchase market is expected to rise again.
It is not difficult to foresee that the high volatility of benchmark interest rates in the financing market, such as the guaranteed overnight financing rate (SOFR), which surged to record levels last week, may become more widespread and intense in the future.
Although in the short term, with the end of a large number of treasury bond auctions last week and the maturity of fixed capital positions at the end of the year, the interest rate of overnight repurchase agreements (loans backed by treasury bond) is expected to become normal this week. According to data released by the New York Federal Reserve on Tuesday, the guaranteed overnight financing rate related to repurchase transactions was 5.38% as of December 29, slightly lower than the historical high of 5.40% previously set.
But the recent sharp fluctuations in these interest rates may only be a microcosm of the future.
Is it feared that QT will be unsustainable?
Wrightson ICAP economist Lou Crandall wrote in a report to clients, "If the Federal Reserve continues to shrink its balance sheet until RRP is completely cleared, we believe that the daily volatility pattern of SOFR is likely to return to a (volatile) pattern similar to before 2020, rather than the more stable pattern in recent quarters."
Prior to the last week of 2023, the Federal Reserve's overnight reverse repurchase tool usage had significantly decreased by nearly $1.4 trillion - to the level of 2021. This is mainly due to the large issuance of bonds by the US Treasury Department and the completion of interest rate hikes by the Federal Reserve.
The Federal Reserve's overnight reverse repo tool can be understood as a reservoir of idle funds for non banking institutions, where the Monetary Fund stores cash and can also act as a buffer for bank reserves. Wall Street strategists estimate that by the end of the second quarter, the overnight reverse repo market will be completely depleted, and the Federal Reserve will have to stop its quantitative tightening (QT) policy - especially if it turns out that bank reserves are actually more scarce than policymakers expect.
That's why Crandall believes that the Federal Reserve must stop the reduction of its balance sheet before the reverse repurchase mechanism is completely exhausted - in this case, any remaining cash in the reverse repurchase tool can be reallocated to the repurchase market once financing market interest rates soar.
Crandall wrote, "As pointed out in the past, we believe there are sufficient reasons to stop QT in the spring or summer of this year, in order to ensure that the daily use of the reverse repurchase mechanism remains structurally positive."