The US funding markets are currently showing positive signs, indicating support for the Federal Reserve's strategy to reduce the excess cash in the financial system. This development comes at a crucial time as Fed officials deliberate on the pace and method of implementing quantitative tightening (QT).
The stability and lack of stress in short-term funding markets provide the Federal Reserve with significant flexibility. This backdrop is crucial as officials discuss the future path of QT. Mark Cabana, Bank of America Corp.'s head of US interest-rates strategy, emphasized the need for policymakers to address the banking system's preference for maintaining high levels of reserves and cash.
Key points of interest in the Fed's assessment of QT include bank reserves and the usage of the Fed's overnight reverse repo facility (RRP). The RRP, a measure of excess liquidity, has seen a reduction of about $1.7 trillion since June 2023. The potential depletion of the RRP raises concerns about the impact on bank reserves and the banking sector's comfort level with lower cash levels.
Strategists from BMO Capital Markets, Ian Lyngen and Vail Hartman, suggest that any discussion or hints regarding QT could introduce unpredictability. They also note that current RRP utilization indicates there is still time before any significant changes need to be made.
As bank reserves decrease, the gap between the effective federal funds rate and the repo-related Secured Overnight Financing Rate (SOFR) is expected to widen. This change is anticipated due to the increased reliance on private market repo transactions, which could drive up market rates and benchmarks like SOFR.
The supply of Treasury bills (T-bills) has increased significantly, with about $2.4 trillion raised since the beginning of 2023. This surge in supply, especially after resolving the debt ceiling issue in June, has slightly impacted T-bill pricing relative to other risk-free rates.
Furthermore, the Fed's balance sheet reduction could influence foreign-exchange swap markets, particularly cross-currency basis swaps tied to the euro and British pound. These effects are expected as US reserve balances decrease more rapidly than those at the European Central Bank and the Bank of England.
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