Pressure Rippling Through Funding Markets Drives Rates Higher

Dynamics in the funding market at the end of August suggest the beginning of a shift where collateral outweighs cash and rates push higher, according to Bank of America Corp.

(Bloomberg) — Dynamics in the funding market at the end of August suggest the beginning of a shift where collateral outweighs cash and rates push higher, according to Bank of America Corp.

Cash parked at the Federal Reserve usually rises at month-end as banks pare their activity for regulatory purposes. Not so last month. Usage of the Fed’s reverse repo facility declined while the rate on overnight general collateral repo rose and transaction volumes underlying the Secured Overnight Financing Rate climbed.  

“These dynamics likely represent a build-up in Street collateral financing needs and a small ripple of upward funding pressure,” Bank of America Strategists Mark Cabana and Katie Craig wrote in a note to clients Friday. “This funding ripple will gradually turn into smaller funding waves & eventual large waves that pressure SOFR higher.” 

There’s been a glut of cash in the financial system since the Covid pandemic upended financial markets and economies, leading to large monetary and fiscal stimulus programs that pumped trillions of dollars into the system. That excess liquidity has finally started draining as the result of the Fed’s latest unwinding of its balance sheet, called quantitative tightening, and Treasury’s deluge of debt issuance, leading some market participants to wonder just when ructions in the funding markets will start to appear. 

Strategists noted these dynamics are similar to those during the US monetary authority’s first round of QT that started toward the end of 2017. That year, the spread between overnight repo and SOFR averaged about 5.5 basis points before shooting up to 19 basis points in 2018 and peaking at 20 basis points in 2019. 

Still, Cabana and Craig expected SOFR to remain anchored to the offering rate on the RRP until the facility’s balances fall toward zero in late 2024, at which point funding pressures will be “more clearly evidenced.” SOFR fixed at 5.31% as of Sept. 7, according to New York Fed data published Friday, which is just above the 5.30% yield at the RRP. 

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