U.S. Financing Market Faces Rising Liquidity Pressures, Will "Money Crunch" Crisis Repeat by Year-End?
The liquidity pressure in the U.S. financing market has recently intensified, causing some on Wall Street to be nervous about greater challenges in the last month of the year. Market participants have indicated that the surge in interest rates related to repurchase agreements (overnight loans collateralized by U.S. Treasury securities) may intensify in December, as regulatory burdens and U.S. Treasury auction settlements clash for the second time in three months, drawing funds away from the financing market. It was these conditions that pushed interest rates to atypical levels at the end of the third quarter.
Peter Nowicki, head of repurchase trading at Wedbush Securities Inc., stated, "Considering the volatility at the end of the quarter, year-end is now a bigger issue."
While the recent market turmoil stems more from the balance sheet constraints of primary dealers rather than the ongoing quantitative tightening by the Federal Reserve, it evokes memories of September 2019, when an increase in government borrowing and corporate taxes led to a shortage of reserves. This resulted in a fivefold surge in overnight repos and the federal funds rate soaring above the target range, forcing the Federal Reserve to intervene and stabilize the market by expanding its balance sheet.
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Bank of America strategists anticipate that dealers will be better prepared for the year-end funding crunch, but they do not rule out the possibility of a repeat scenario, as government debt still floods the balance sheets of dealers. Complicating this potential issue further is the massive Treasury coupon auction settlement of an estimated $147 billion on December 31, about 25% higher than on September 30.
The financing market will also feel pressure from Global Systemically Important Banks (GSIBs). At year-end, a brief analysis of GSIBs' risk exposure will determine whether their capital requirements will increase in the next full fiscal year. Jan Nevruzi, U.S. interest rate strategist at TD Securities, stated that, as a result, it is easier to reduce repo activity when institutions tidy up their balance sheets, adding that companies are unlikely to engage in "low-margin business."
Nevruzi said, "If you want to shrink the balance sheet, this is the area you would look at first."
Conversely, dealers may increasingly rely on sponsored repos, which allow lending institutions to trade with counterparties such as money market funds and hedge funds without regulatory constraints on their own balance sheets. These agreements are effectively "sponsored" or cleared through the fixed-income clearing corporation's repo platform, enabling dealer banks to net settle with both parties and reduce the capital they need to hold.
Data from the Depository Trust & Clearing Corporation shows that sponsored repo activity totaled $1.78 trillion as of September 30, falling back to $1.58 trillion on October 4.
The surge in sponsored repo activity highlights the growing demand from hedge funds, as their activities outpace cash lending institutions. This may be because dealers do not have enough cash, and lending counterparties sign up to participate in sponsored repos, creating a risk of chaos around year-end. In fact, due to dealers rejecting money fund funds, the balance of the Federal Reserve's overnight reverse repo tool nearly doubled in the second half of September, reaching $466 billion.Nowicki stated: "The bigger issue is the misalignment between cash lenders and borrowers. It appears that if lending institutions do not lend, this activity could potentially surge."
Then there is the Federal Reserve's Standing Repurchase Facility (SRF), a mechanism that allows eligible institutions to borrow cash at a rate that aligns with the upper bound of the Federal Reserve's policy target range (currently a minimum of 5%) in exchange for U.S. Treasury securities and agency bonds. This move is intended to set a cap on repurchase rates, but market participants question its effectiveness, as overnight repurchase rates have soared to 5.9%, while counterparties have only withdrawn $2.6 billion from the SRF.
Wells Fargo interest rate strategist Angelo Manolatos said: "I believe that if volatility increases and rates rise by the end of the year, then all these factors combined could mean that the SRF is indeed being used in a more meaningful way."
Despite all these factors, market participants may still choose to lock in financing rates before January 2nd, rather than locking in overnight rates as soon as possible. Therefore, this could alleviate pressure in the repurchase market by the end of the year.
RBC Capital Markets' Head of U.S. Interest Rate Strategy, Blake Gwinn, said: "It's always paradoxical, right? The more concerned we are in October, the smaller the problem becomes."
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