(Bloomberg) -- Last month’s surge in overnight funding rates arose from a perfect storm. Other squalls may arise before year-end.
The Federal Reserve’s temporary cash injections prevented a repeat of the funding squeeze on Monday, the last day of the third quarter and a moment recent history suggests could’ve been stressful.
U.S. money market rates look normal again and the Fed’s daily repo operations haven’t been fully subscribed since Sept. 25. But until traders hear whether the central bank has a long-term fix for foundation of the financial system, they’ll eye some dates in the coming months with trepidation.
Some of the catalysts that whipped markets up last month will be back, according to Thomas Simons, money market economist at Jefferies. Another $381 billion of Treasury auctions are on the calendar for the fourth quarter -- though that’s smaller than the flurry of auctions that fueled repo turmoil in mid-September. Treasury cash balances will continue to rise, and more corporate taxes will be paid. Add to this a couple of long weekends, which can stir volatility.
Then there are wild cards: the U.K.’s Oct. 31 deadline to leave the European Union and the risk of other geopolitical strife.
“The confluence of events could be much worse at year-end,” said Priya Misra, head of global rates strategy at TD Securities.
The current tranquility faces its first big test soon. On Oct. 10, the Fed will do its last scheduled overnight repo operation, the daily action that’s helped calm the market since it was first run on Sept. 17. Scott Skyrm of Curvature Securities worries about the Fed’s term lending coming out of the system, plus the $190 billion of net new Treasuries hitting the market next week.
All of this would be less worrisome if market participants were confident that the system is well stocked with liquidity. But reserves are likely to shrink further between now and year-end. That’s due to the growth of currency in circulation and an estimated $60 billion increase in cash balances at the Treasury, by Jefferies’ estimates. The Treasury releases its refinancing statement on Oct. 28.
And the largest liquidity providers -- those designated as global systemically important banks, or G-SIBs -- may have less leeway to lend into tightening markets, which could saddle them with higher capital charges in a year-end regulatory review of their balance sheets.
This all sets up for a possible repeat of last year’s market upheaval: On the last day of 2018, the market got messy. The rate on overnight repurchase agreements spiked by more than 3.5 percentage points to 6.125%, a level unseen since 2001, based on ICAP pricing. And that was when reserves were arguably still “ample.”
The Fed is likely to intervene if overnight repo jumps again, said Misra, but the market will need to see a more durable solution, consistent with the ample reserves regime that Fed Chairman Jerome Powell says he wants to preserve. Misra will examine the minutes from the Fed’s September meeting to see how seriously policy makers are taking the situation, and what action they favor.
The minutes should at least help answer one burning question for repo watchers, according to Misra: “Do they appreciate that reserves may have declined too much? This is what the Fed has actually never to date accepted.”
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