By Gertrude Chavez-Dreyfuss and Davide Barbuscia
NEW YORK (Reuters) -A surge in U.S. Treasury bill issuance in recent months has reduced liquidity in the financial sector, stoking investor concerns that funding markets could face a September squeeze.
That could create ripple effects through markets by reducing demand for assets like stocks and corporate bonds, and pushing some investors to set cash on the side in anticipation of volatility.
Some say there is 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.
“There is some concern that we could have a repeat of September 2019 at quarter-end due to technicals, corporate tax days, and coupon settlements,” said Teresa Ho, head of short duration strategy at J.P. Morgan in New York.
In September 2019, overnight funding costs in the repurchase (repo) market spiked due to a large drop in bank reserves amid large corporate tax payments and payments for Treasury debt, forcing the Fed to inject liquidity in repo markets.
Some measures of liquidity are already signaling stress ahead, such as a higher cost of borrowing cash overnight collateralized by Treasuries. Still, money market conditions are different. The Fed has launched the Standing Repo Facility (SRF) — that could be tapped by banks for emergency liquidity, and bank reserves – the biggest component of overall financial sector liquidity – are much higher at $3.2 trillion than in 2019.
However, the Fed has been shrinking its bond holdings for over three years, drawing attention to liquidity. At the same time, rapid issuance of Treasury bills by the government after the debt ceiling was raised in July, has prompted traders to anticipate potential stress.
Pressure could increase around the September 15 corporate income tax date and the end of the September quarter, when traders say banks tend to reduce intermediation activity.
“September tends to be one of the more volatile months and so we are really keeping a close eye on repo and front-end funding spreads,” said Clayton Triick, head of portfolio management of public strategies at Angel Oak Capital Advisors.
Triick is keeping money on the side in case money market volatility leads to wider credit spreads, which he said would be an opportunity to buy more corporate bonds.
SEPTEMBER STRESS
Generally, an increase in government borrowing coincides with a decline in demand for the Fed’s overnight reverse repo facility (RRP), through which money funds lend to the central banks, or with a drop in bank reserves parked at the Fed.
These two money pools are monitored by the Fed to assess financial sector liquidity as it continues shrinking its balance sheet through quantitative tightening.
“We expect U.S. bank reserves to continue seeing drawdowns in the upcoming months as T-bill net supply increases,” Citi analysts said in a recent note, which could lead to a potential liquidity crunch this month.
Among the measures of liquidity signaling stress is that the Secured Overnight Financing Rate (SOFR), the cost of borrowing cash overnight collateralized by Treasuries, rose to 4.42% last Friday, the highest in two months, signaling pressure in a key funding market for Wall Street. On Thursday, SOFR pulled back a bit to 4.39%.
Meanwhile, the spread between one-month forwards of SOFR and the effective fed funds rate, at which banks lend overnight unsecured loans to each other, stood at minus 7.5 basis points (bps) on Thursday, the most negative level on record.
This means that the forwards market expects SOFR to trade 7.5 bps higher than fed funds by end-September, suggesting tighter repo funding conditions. SOFR typically tends to be lower than fed funds by five to 10 bps because the former carries minimal credit risk being secured by Treasuries.
Nafis Smith, head of taxable money markets at Vanguard, said while repo spreads are experiencing mild and periodic pressure, these are typically short-lived, in contrast to 2019 when they were persistently elevated leading up to the September dislocation.
He added that worries about a 2019-style funding disruption appear “overly pessimistic.”
DECLINING BANK RESERVES
Usage of the Fed’s RRP facility has also fallen sharply, from a peak of $2.6 trillion at the end of 2022 to $29 billion on Thursday, leaving bank reserves as the main source of financial sector liquidity.
Lou Crandall, chief economist at Wrightson ICAP, said he expects more funding pressure this quarter compared with end-June because of declining bank reserves, which could necessitate higher usage of the Fed’s SRF. Fed data showed that banks borrowed $11.1 billion from the SRF last June 30 backed mostly by Treasuries, the largest borrowing since its launch four years ago.
Crandall said he expects SRF borrowings as high as $50 billion at end-September.
He added that bank reserves could well dip below $3 trillion by end-September as market participants settle a substantial amount of Treasury debt and pay corporate taxes ahead of a September 15 deadline.
To be sure, some market players argued that any funding squeeze would be fleeting. Since quarter-end liquidity tightness is expected, the odds of investors being blindsided are slim.
“It never seems like funding markets blow out when risks are well-telegraphed,” said Jonathan Cohn, head of U.S. rates desk strategy at Nomura.
“The market pre-positions, precautionary liquidity is sourced, so you can have these known periods of pressure like a reporting date, that come and go, that don’t require any direct Fed intervention.”
(Reporting by Gertrude Chavez-Dreyfuss and Davide Barbuscia; editing by Megan Davies and Nick Zieminski)
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