The 12 trillion financing market is in crisis! Institutions urge the Federal Reserve to step up rescue efforts

The $12 trillion short-term financing market—a key source of daily liquidity for Wall Street—is experiencing undercurrents and mounting pressure, prompting an increasing number of institutions to call for stronger responses from the Federal Reserve to ease liquidity strains.

Institutions such as Bank of America, SMBC Nikko Securities, and Barclays have warned that the Federal Reserve may need to take action, such as increasing lending in the short-term market or directly purchasing securities to inject funds into the banking system and alleviate market pressures that have already pushed up overnight rates.

“Given the recent market pressures, the Federal Reserve seems to be only gradually adjusting its balance sheet policy,” said Gennadiy Goldberg, Head of US Rates Strategy at TD Securities. “Some investors believe the Fed may be acting too slowly to prevent a shortage of reserves.”

In recent weeks, a series of key short-term rates have remained elevated—from benchmark rates tied to overnight repurchase agreements (loans collateralized by government bonds) to the Fed’s own key policy rate (which typically does not move between rate decisions, but has risen within its range four times in the past two months).

Among them, the Secured Overnight Financing Rate (SOFR) even experienced its largest single-day fluctuation outside of a Fed rate hike cycle since March 2020 (the peak of the pandemic).

Despite Fed rate cuts, short-term rates remain under pressure

Behind the liquidity crunch is the increase in US Treasury issuance—a move that has drained large amounts of cash from the short-term market, reducing the funds available in the banking system.

The government shutdown, which only ended late Wednesday local time, further exacerbated the situation by delaying federal spending that could have boosted liquidity. Meanwhile, the Fed’s ongoing balance sheet reduction (i.e., quantitative tightening, QT) has also contributed to the pressure.

Even though the Fed recently announced it would stop reducing its Treasury holdings starting December 1, market pressures have not eased. Some worry that the end of the government shutdown deadlock will not completely resolve the issue.

The Fed has announced it will stop balance sheet reduction next month

On Wednesday, Roberto Perli, a New York Fed official responsible for the Fed’s securities portfolio, stated that the recent rise in financing costs indicates that banking system reserves are no longer ample, and the Fed “won’t have to wait long” before initiating asset purchases. This echoes similar statements from policymakers in recent days.

A spokesperson for the Federal Reserve Board declined to comment.

For market participants, this signal is welcome. The core interest lies in the smooth functioning of key financial market mechanisms—cash-rich institutions such as money market funds lend short-term funds here, while investors like hedge funds borrow against high-quality assets such as US Treasuries, providing capital for popular strategies like basis trades.

The market is concerned that insufficient liquidity could trigger volatility, weaken the Fed’s ability to control interest rate policy, and in extreme cases, force investors to unwind positions, thereby impacting the US Treasury market, which serves as the global benchmark for borrowing costs—at a time when the economic outlook remains highly uncertain.

For many seasoned market participants, memories of September 2019 remain vivid. At that time, a key overnight rate soared to 10%, forcing the Fed to inject $500 billion into the financial system to intervene.

So far, the financing market is still operating smoothly, and lending support tools established by the Fed in recent years—such as the Standing Repo Facility (SRF), which allows eligible institutions to borrow against Treasuries and agency bonds—have helped curb sharp increases in repo rates, with the tool being used frequently in recent weeks.

Policymakers have also remained cautious during the balance sheet reduction process—back in April this year, given congressional debates over the debt ceiling, the Fed had already slowed the pace of balance sheet reduction, while noting that the rebuilding of the Treasury’s cash balance could put additional pressure on reserve levels.

“You could say the situation in 2019 was somewhat of a disaster,” said Zachary Griffiths, Head of US Investment Grade Bond and Macro Strategy at CreditSights Inc. “What we’ve observed in the financing market recently is more of a controllable signal indicating that reserves have basically fallen to a level suitable for stopping balance sheet reduction.”

Although the market generally expects pressures to ease in the coming weeks as the Treasury plans to reduce the size of weekly bond auctions and the Fed’s idle funds are released after the government shutdown ends, there are still risks of volatility at year-end. Typically, banks reduce repo market activity before year-end to meet regulatory requirements and improve their balance sheets, which could exacerbate year-end turbulence in the financing market.

Cleveland Fed President Beth Hammack stated last week that as reserves continue to approach “ample” levels (latest data shows current reserves at $2.85 trillion), officials are trying to determine an acceptable range of volatility.

“I think a certain degree of volatility in front-end rates is a good thing, as long as they remain within our policy range,” Hammack said at the Economic Club of New York. “For example, a 25 basis point fluctuation—I think that’s healthy.”

However, Dallas Fed President Lorie Logan, who worked for many years in the New York Fed’s markets division, said last month that if repo rates continue to rise, the Fed will need to purchase assets, adding that the size and timing of purchases should not be mechanical.

For some market participants, the divergence among policymakers over the reasonable operating range for money markets, as well as the overall lack of clear guidance, is frustrating.

“Where do you want the average level of money market (rates) to be? What constitutes effective control of the money market?” said Mark Cabana, Head of US Rates Strategy at Bank of America. “In our view, if you expect repo rates to self-correct, then it’s unlikely the situation will reach the outcome the Fed desires.”