Fed liquidity facilities see tepid demand despite quarter end, repo rates climb

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By Michael S. Derby and Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) -Federal Reserve liquidity facilities saw much less interest from Wall Street than expected on Tuesday as the third quarter came to a close, though a climb in repo rates showed some liquidity pressure.

Quarter ends generally see challenging money market conditions as some firms pull back from the market and managing liquidity becomes challenging amid volatile interest rate movements. This quarter end was expected to be particularly choppy because overall liquidity levels have been declining as the Fed shrinks its holdings of bonds in a process known as quantitative tightening, or QT.

“Repo rates did spike,” said Tom di Galoma, managing director of rates and trading at Mischler Financial. “There was a lot of pressure at quarter ends, just getting deliveries done and everything else. It was pretty tricky and it’s just that the system is overwhelmed.”

There had been concerns on Wall Street of a mild risk of a repeat of 2019 when a liquidity shortage caused a spike in short-term borrowing rates until the Federal Reserve intervened in overnight markets to alleviate the crunch.

The general collateral or repo rate opened at 4.45% earlier on Tuesday and rose as high as 4.60%, ending the session at 4.35%, according to Curvature Securities.

QT is designed to pull liquidity from the financial system and has aimed to remove the excess cash the Fed injected into the system during the COVID pandemic. With reverse repo usage recently at negligible levels, QT is now eating away at underlying liquidity levels, increasing the risk of unexpected friction in markets. 

The challenge for the Fed and others is knowing when enough money has been taken out. The last time the Fed engaged in QT, it saw an unexpected liquidity shortfall in September 2019 that caused money market rates to spike, forcing the end of that chapter of drawdown.

Ahead of Tuesday, some market participants had estimated that the SRF, started in 2021 and thus far little used, could see as much as $50 billion in usage, before being quickly unwound. Instead, the Tuesday SRF borrowing was even short of the $11 billion seen as the second quarter ended.

“I do think that based on what happened so far, it seems to be a little bit less extreme, perhaps than initially anticipated,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities.

The SRF is intended to serve as a shock absorber for temporary market liquidity shortfalls but there have been long-standing questions about its ability to fulfill that role. Some have worried that some firms would not use the SRF for fear of signaling to others they are in some form of trouble. By law those who use the facility will be revealed with a two-year lag.

But it appears economics might have been the main force warding off usage on Tuesday. One trader noted rates for borrowing cash were higher on Monday than they were on Tuesday, suggesting less urgency to tap Fed cash.

The latest Senior Financial Officer Survey released in March showed banks would actively consider placing a bid at the SRF, rather than borrow from the repo market, once rates at the latter rise 37.5 basis points over the SRF level, currently at 4.25%.

That said, Joseph Abate, head of rates at SMBC Nikko Securities, noted “the reluctance to use the SRF is kind of diminishing and so we should see more willingness to use the program.”

(Reporting by Michael S. Derby; Editing by Chizu Nomiyama, Andrea Ricci and Chris Reese)