(Bloomberg) -- The latest heightened liquidity pressures in the US funding market have some on Wall Street nervous about even greater challenges in the final month of the year.
Market participants say a spike in interest rates tied to repurchase agreements, which are overnight loans collateralized by US Treasuries, could intensify in December as both regulatory burdens and Treasury auction settlements collide for the second time in three months, siphoning cash out of the funding market. It was those conditions that pushed rates to atypical levels at the end of the third quarter.
“Year-end is now a bigger issue given the volatility” at quarter-end, said Peter Nowicki, head of repo trading at Wedbush Securities Inc.
While the most recent market turbulence stemmed more from primary dealers’ balance-sheet constraints instead of the Federal Reserve’s ongoing quantitative tightening, it evoked memories of September 2019 when an increase in government borrowing and a corporate tax payment created a shortage of reserves. That resulted in a five-fold surge in overnight repo and a spike in the federal funds rate above the target range, forcing the Fed to intervene by expanding its balance sheet to stabilize the market.
Bank of America Corp. strategists expect dealers to be better prepared for year-end funding constraints, but they aren’t ruling out a repeat as dealers’ balance sheets remain bloated with government debt. Compounding that potential problem are big Treasury coupon auction settlements for an estimated $147 billion on Dec. 31 — about 25% larger than ones on Sept. 30.
Funding markets will also feel pressure from global systemically important banks, or GSIBs. At year-end, a snapshot of GSIBs’ exposures is taken to determine whether their capital requirements will increase for the following full calendar year. So when institutions are tidying up their balance sheets, it’s easier to trim repo activity, according to Jan Nevruzi, a US rates strategist at TD Securities, adding that companies are less likely to transact in “low margin businesses.”
“That’s the first area you look at if you want to trim your balance sheet,” Nevruzi said.
Instead, dealers will likely rely more on sponsored repo, which allows lenders to transact with counterparties like money-market funds and hedge funds, without bumping up against regulatory constraints of their own balance sheets. These agreements are effectively “sponsored” or cleared via the Fixed Income Clearing Corp.’s repo platform, thereby allowing dealer-banks to net two sides of a trade and hold less capital against it.
Sponsored repo activity totaled $1.78 trillion as of Sept. 30 before retreating to $1.58 trillion on Oct. 4, Depository Trust and Clearing Corp. data show.
The surge in sponsored repo activity underscores the growth of demand from hedge funds as their activity outpaced that of cash lenders. That may be because dealers don’t have enough cash lender counterparties signed up to participate in sponsored repo and that creates risks of dislocations around year-end. In fact, balances at the Fed’s overnight reverse repo facility nearly doubled in the second half of September to $466 billion because dealers were turning away money-fund cash.
“The bigger problem is the dislocation of cash lenders and borrowers,” said Nowicki. “It seems if the lenders don’t lend, we could get a spike.”
Then there’s the Fed’s Standing Repo Facility, which allows eligible institutions to borrow cash in exchange for Treasury and agency debt at a rate in line with the top of the Fed’s policy target range — currently a minimum of 5%. This is meant to help put a ceiling on repo rates, though market participants are questioning its efficacy as overnight repo have surged to 5.9% and counterparties only tapped the SRF for $2.6 billion.
“I think if year-end is a little more volatile, if rates are higher, a confluence of all these things could mean the SRF does get more meaningful usage,“ said Angelo Manolatos, a rates strategist at Wells Fargo.
Despite all these factors, there’s still a chance that market participants will be motivated to lock in funding rates through Jan. 2 instead of overnight as soon as possible. As a result, that might alleviate repo market pressures at year-end.
“That is always the paradox, right?” said Blake Gwinn, head of US interest rate strategy at RBC Capital Markets. “The more we worry about it in October, the less of a problem it is.”
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