End Nigh for Fed’s Quantitative Tightening
We expect the Secured Overnight Financing Rate (SOFR) to yield more than the US Federal Reserve’s (Fed’s) RRP rate. General Collateral Financing (GCF) repo and SOFR are trending higher and perhaps headed for additional funding stress.
The Fed’s Reverse Repurchase Program (RRP) is an important tool the Fed uses to manage short-term rates, particularly in recent years. From mid-2022 to mid-2023, the program was pulling over $2 trillion of cash from the system and helping the Fed keep short-term rates within its target rate range.
Recently, RRP balances have dropped to below $200 billion, and if the current trend continues, balances may hit zero sometime in Q1 2025. If this happens, the Fed should stop its quantitative tightening (QT) program sometime after that.
The main driver of ending QT would be if the Fed felt that it was beginning to drain too much liquidity from the market, which could lead to disfunction in the repo markets. What happened in September 2019 was the result of too little liquidity, the exact opposite of what we experienced in 2022 and 2023, when there was too much liquidity in the system.
We have already seen significant growth in the repo balances that primary dealers are carrying. We can see in Figure 2 that those balances are up by over $1 trillion over the past three years, implying dealer resiliency in the current market.
We expect the Secured Overnight Financing Rate (SOFR) to yield more than the Fed’s RRP rate, which we last saw at the end of the previous rate hike cycle (2018) and in 2019.
General Collateral Financing (GCF) repo and SOFR are trending higher and perhaps headed for additional funding stress. To try to minimize this stress, the Fed reduced the pace of QT for US Treasuries back in May, with the aim to let QT run “in the background” rather than causing similar stress to 2019. Given the size of the Fed’s balance sheet, this approach makes sense, and will help to bring balances in line with historical averages.
To help combat market stress, the Fed established the Primary Dealer Standing Repo Facility (SRF) as an overnight loan facility that provides funding to dealers in exchange for eligible collateral. This facility was utilized on 30 September with $2.3 bn of loans.
There are some operational challenges that need to be worked out for the Fed to properly manage its policy rate and, most importantly, reduce volatility in the Secured Overnight Financing Rate – London Interbank Offer Rate’s replacement and the rate that so many financial instruments are benchmarked to.
The most recent Fed Meeting Minutes detailed a discussion to drop the RRP rate to the lower end of the Fed’s policy rate range. This means if it does cut rates by 25 bp in December, it could reduce the RRP rate by 30 bp, indicating that the Fed is keen to keep a close eye on short-term rates and bank reserves.
This type of move is not unprecedented, with the 2018 rate hike cycle exhibiting similar moves, though in the opposite direction: The Fed raised the RRP and IOR rates by only 20 bp when it was raising policy rates by 25 bp.
The leading indicator will be excess reserves that are held at the Fed by its member banks. As illustrated in Figure 4, beginning in 2017, those reserves started to decline as the Fed continued to drain liquidity with its QT program.
At that time there was not the excess liquidity in the system there is today; the RRP was at zero balance. Today the RRP’s balance has shrunk dramatically but is still well over $100 bn. Once the balance declines to zero, we should start to see reserves decline as they are needed to buy the assets rolling off the Fed’s balance sheet. This shift should cause funding pressures, higher yields, and ultimately will be good for our cash investors, though a problem for the Fed.