Analysis-What Fed cut? US repo rates still high as liquidity tightens into year-end

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By Gertrude Chavez-Dreyfuss and Davide Barbuscia

NEW YORK (Reuters) -The cost of U.S. overnight funding in the repo market has stayed stubbornly high and is expected to remain elevated going into year-end despite recent Federal Reserve easing, adding another layer of stress to already fragile financial markets.

A spike in repurchase or repo rates signals liquidity is scarce and raises funding costs across the financial system. 

The general collateral, or GC repo rate, which is the cost of borrowing short-term cash using Treasuries or other debt securities as collateral, opened at 4.05% on Tuesday, according to repo traders. That’s five basis points higher than the upper end of the Fed’s target range of 3.75%-4.00%.

On October 31, the GC rate spiked to 4.25%, driven by the typical month-end surge in repo rates as banks step back from intermediation to manage their own higher balance sheet costs tied to reporting requirements. A similar surge is expected as the market approaches year-end.

Overnight repo rates also have traded consistently above the Interest Rate on Reserve Balances (IORB) currently at 3.90% since mid-October, which suggest bank reserves are dipping into levels that could raise red flags. 

As of last week, reserves dropped to $2.8 trillion from $3.3 trillion a few months ago—just shy of the $2.7 trillion level Fed Governor Christopher Waller deems “ample” to prevent market disruptions.

“We suspect that markets may be more vulnerable to overnight funding rate pressure than they were in 2019,” said Joseph Abate, head of rates strategy at SMBC Nikko Securities, referring to September of that year when funding costs soared due to a large drop in bank reserves as corporations tried to meet a tax deadline and make payments for Treasury debt settlements.

He cited large hedge funds’ Treasury long positions in the cash market in so-called basis and relative value trades, with repo financing also growing sharply this year. In a basis trade, for instance, hedge funds would typically buy cash Treasuries and simultaneously hedge by selling futures to asset managers who will end up holding a long position on them. To finance that long position, hedge funds tap the repo market.

Abate said hedge funds’ long positions swelled by nearly $400 billion in the first six months of the year to $2.4 trillion. Their use of repo funding also increased by nearly $700 billion this year and is more than twice as large as in 2019, he added.  

TIGHTER OVERNIGHT LIQUIDITY   

Tighter overnight liquidity reflects several factors, including a surge in U.S. bill issuance by the Treasury to build its cash balance, and the impact of the record 43-day U.S. government shutdown that ended last week. The shutdown meant that the U.S. Treasury accumulated funds in its account at the Fed called the Treasury General Account (TGA), as government payments of salaries and other expenses were curtailed. 

At the same time, when new Treasuries are issued, investors such as dealers, banks and money market funds must pay cash to the U.S. Treasury on settlement day. This payment drains reserves from the private sector and moves them to the TGA. As available reserves decline it gets costlier to borrow cash in the repo market, pushing rates higher.

“There’s no doubt that with the government shutdown and the increase in the TGA and the fact that there are no balances left at the reverse repo facility, we are operating on the edge of what an ample reserve regime is,” said Brij Khurana, portfolio manager at Wellington Management in Boston.

Scott Skyrm, executive vice president at Curvature Securities, also pointed to the swelling U.S. budget deficit this year, which needs to be financed by new debt.

“If we have $1.8 trillion in the budget deficit, that’s an extra $100 billion of Treasuries coming into the market every month,” said Skyrm. “Somebody has to pay for those and that’s cash being used to finance those Treasuries.”

Still,  the clearest sign of stress, analysts said, is the recent rise in the effective fed funds rate (EFFR) — the interest banks charge each other for overnight loans to meet reserve requirements. 

Analysts attributed this to the pull higher from repo rates. The EFFR is currently at 3.88%, up from 3.86% touched on October 31 two days after the Fed cut interest rates by 25 basis points.

Some market participants also warned repo pressures could trigger the unwinding of leveraged trades in riskier assets such as stocks and bitcoin, both of which have seen sharp selloffs in recent weeks.

To be sure, the Fed has the ultimate backstop —  the Standing Repo Facility (SRF) — which serves as a shock absorber for temporary market liquidity shortfalls, although there have been long-standing questions about its ability to fulfill that role. 

Fed officials have urged banks to use the Standing Repo Facility (SRF) without concern that borrowing from the central bank signals distress. Last week, New York Fed President John Williams met with major Wall Street banks to discuss SRF usage and gather feedback to ensure the tool remains effective in managing interest rates.

(Reporting by Gertrude Chavez-Dreyfuss and Davide Barbuscia; Editing by Alden Bentley and Anna Driver)