Recent liquidity pressures in the U.S. financing market have raised concerns among Wall Street participants about potential challenges as the year-end approaches. There is apprehension that rates related to repurchase agreements (repos), which are overnight loans secured by U.S. Treasury bonds, may spike in December. This surge could result from regulatory burdens and conflicting U.S. Treasury auction settlements, which have previously pushed rates to atypical levels at the end of the third quarter.
Peter Nowicki, head of repo trading at Wedbush Securities Inc., highlights the impact of quarter-end volatility, which now presents a larger year-end problem. The turmoil seems to originate more from balance sheet constraints of primary dealers rather than the Federal Reserve's ongoing quantitative tightening. However, it evokes memories of September 2019 when government borrowing and corporate tax increases led to a reserve shortfall, causing the overnight repo rate to quintuple, and forcing the Fed to intervene by expanding its balance sheet.
Bank of America strategists predict that dealers will be better prepared for year-end funding pressures but do not dismiss a repeat of past issues due to government debt saturating dealer balance sheets. Further complicating matters is the forecasted settlement of a $147 billion Treasury coupon auction on December 31, significantly higher than at the end of September.
Global systemically important banks (GSIB) also contribute to these strains, as their year-end risk exposure assessments may increase capital requirements for the next calendar year. Jan Nevruzi, a U.S. rates strategist at TD Securities, suggests that institutions might cut back on repo activities to streamline balance sheets, as such transactions often yield low profits. Dealers might increasingly rely on sponsored repos, enabling lenders to engage with money market funds and hedge funds without balance sheet restrictions. These transactions are "sponsored" or cleared through fixed-income clearing platforms, allowing for net settlements by dealer banks.
As of September 30, sponsored repo activity totaled $1.78 trillion, retreating to $1.58 trillion by October 4, according to the U.S. Depository and Clearing Corporation. This surge reflects heightened hedge fund demand, surpassing that of cash lenders, potentially signaling disorder toward year-end. In fact, due to dealer reluctance to accept money funds, the Federal Reserve's overnight reverse repo tool balance nearly doubled in late September to $466 billion.
Nowicki highlights the misalignment between cash lenders and borrowers, noting that if lenders withhold funds, repo activity could soar unexpectedly.
The Federal Reserve's Standing Repo Facility (SRF) provides another mechanism, allowing eligible institutions to borrow cash at the policy's upper target range (currently a minimum of 5%) in exchange for U.S. Treasury or agency bonds. However, with repo rates already reaching 5.9% and limited SRF usage, market participants question its effectiveness. Angelo Manolatos, a Wells Fargo rates strategist, suggests that heightened year-end volatility could boost SRF usage substantially.
Despite these factors, market participants may opt to lock in financing rates by January 2 instead of securing overnight rates immediately, potentially alleviating year-end pressure on the repo market. RBC Capital Markets' U.S. rates strategy chief, Blake Gwinn, notes the paradoxical nature of these concerns, where increased October anxiety might lead to a smaller issue.
