It may be months before Federal Reserve officials are ready to take any action on interest rates, so traders are focusing on something else that ordinarily gets less attention: The undercarriage, or plumbing, of funding markets, where things could start to go awry in certain scenarios and undermine confidence in the U.S. banking system.
Large financial firms like money-market funds and banks use overnight programs such as the Fed’s reverse repurchase facility to park large amounts of cash on a short-term basis. They do so via transactions known as reverse repos, which involve the brief exchange of cash for high-quality securities like Treasurys that are on the central bank’s balance sheet, temporarily reducing the supply of reserve balances in the banking system.
This plumbing is what helps the Federal Reserve keep its main policy rate target in check and allows markets to function more smoothly. It’s part of a process that typically runs quietly in the background of financial markets, but arguably could end up becoming as disruptive as it was in September 2019 when volatility gripped the overnight funding market amid a big decline in bank reserves.
The year 2019 “was one example of what could happen again, when banks ran into reserve scarcity, and it was a situation that was unfolding very rapidly and proved to be very disruptive for the banking system,” said economist Derek Tang of Monetary Policy Analytics in Washington.
“It was quite hard for Fed officials to figure out what to do in real time. If it happens again, they might be better prepared, but it is unclear if any of their actions would be enough to offset the risk.“
At the moment, usage of the reverse-repo facility is dwindling, with the amount of daily balances shrinking to $519.7 billion as of Tuesday from as high as $2.55 trillion on Dec. 30, 2022. The fear is that once RRP usage drops to zero, an environment may emerge in which banks no longer have abundant reserves, and these concerns are growing just ahead of the one-year anniversary of Silicon Valley Bank’s collapse.
Bank reserves versus usage of reverse repo facility
BNY Mellon Markets, Federal Reserve Board, New York Fed
For now, however, bank reserves are still holding up even as RRP usage is shrinking. Reserves are the minimal amounts of cash that institutions are required to have on hand to meet Fed requirements in the event of unexpected and large demands for withdrawals. California-based Silicon Valley Bank collapsed last March after too many customers pulled deposits at roughly the same time, creating a classic bank run that threatened to shatter confidence in the U.S. banking system and forced regulators to bolster their oversight.
So far this year, funding markets have exhibited little — if any — sign of the strains seen in late 2023, according to John Velis, an Americas macro strategist for BNY Mellon. Last year’s strains took the form of a November spike in short-term lending rates within the overnight funding market, followed by a repeat in December. Stresses haven’t appeared in this corner of the financial market as they did at the end of last year, and liquidity appears to be sufficient for now, Velis wrote in a note this week.
As long as bank reserves remain abundant, this gives the central bank more leeway to continue reducing the size of its $7.58 trillion balance sheet, under the process known as quantitative tightening. The Fed has been using QT to tighten financial conditions and to drain liquidity out of the system, with much of that effort showing up in falling RRP usage instead of bank reserves so far.
“Once RRP reaches zero in May or June, there may no longer be abundant reserves in the banking sector, which increases the probability of an accident somewhere in the plumbing of the financial system,” said Torsten Slok, chief economist at Apollo Global Management in New York. In a note over the weekend, he cited potential consequences such as “less support for T-bills [Treasury bills], duration, and credit markets, or stresses in money markets similar to what we saw in September 2019.”
Steadily falling balances in the Fed’s overnight reverse repo program since 2023.
Federal Reserve Bank of New York, Haver Analytics, Torsten Slok
According to Tang, the economist from Monetary Policy Analytics in Washington, “all of these issues are converging at the Fed’s balance sheet, which is the venue or site where these policies are decided and which flows through to financial conditions. So the moving parts are what interest the markets.
“People are afraid that there’s a calm before the storm. In other words, things work until they do not,’’ he said. Via phone, Tang said that “2024 was always going to be the time Fed officials would likely revisit their balance-sheet plans, so, logistically, it makes sense that if Fed officials are not moving on interest rates, that maybe they have more time to devote to these other issues.’’
The minutes of the Fed’s Jan. 30-31 meeting noted that many policymakers mentioned March 19-20 as a possible time to hold an in-depth discussion that would help guide them on an eventual decision to slow down the pace of QT, a process that shrinks the size of the Fed’s balance sheet. Concerns about maintaining ample bank reserves will likely determine the Fed’s thinking on when to slow, and eventually stop, QT.
But Velis of BNY Mellon questioned the need for such a discussion soon, citing a current “lull” in recent developments that’s mostly attributable “to policy uncertainty, with expectations of upcoming rate cuts having been pushed deeper into the year.”
“Given steady repo rates this year, a lull in RRP drainage this month, and still-quite-abundant reserves, one might wonder why this discussion on reducing the pace of QT is taking place,” Velis said. He added to this list of developments easing concerns about the so-called basis trade, a way in which hedge funds have profited on the differences in prices between Treasurys and Treasury futures. These developments “are all part of the same ball of wax” and point to less borrowing in Treasurys, according to the strategist.
On Wednesday, the bond market remained relatively steady after a modest downward revision to fourth-quarter U.S. GDP, with traders looking ahead to Thursday’s release of the Fed’s preferred inflation gauge, known as the personal-consumption expenditures price index, for January. The policy-sensitive 2-year rate
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was down 2.5 basis points at 4.687%, while the benchmark 10-year yield
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fell 2.4 basis points to 4.29% in New York afternoon trading.
“Investors are really aware that things which were going on in the background over the last 1.5 to 2 years are now potentially going to change, and adjustments can always be potentially messy,’’ said Will Compernolle, a macro strategist for FHN Financial in New York.
