US money market at risk of fresh bout of stress, Wall Street banks say

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Wall Street banks warned that tension in US financial markets could flare up again and prompt the Federal Reserve to take faster action to curb another rise in short-term interest rates.

Short-term financing rates stabilized this week after signs of tension late last month in a vital section of the financial system sparked concern among some bankers and policy makers.

The spread between the key market-based interest rate known as the triple repo and set by the Federal Reserve reached its highest level since 2020 last Friday, despite the central bank saying it would halt a program to shrink the size of its balance sheet on December 1.

Triple repo rates fell back in line with the Fed’s rate on reserve balances this week, as pressure on money markets eased. But market participants remain concerned about the specter of another jump in repo rates in the coming weeks.

“I don’t think it was just a one-off anomaly of a few days of volatility,” said Deirdre Dunne, head of interest rates at Citigroup on Wall Street, who also serves as chairman of the Treasury Borrowing Advisory Committee.

Scott Skyrm, executive vice president at repo market specialist Curvator Securities, added that while markets are “back to normal,” partly due to banks exploiting Fed easing to ease pressures in money markets, “funding pressures will return at least at the end of the month and the end of next year.”

Samuel Earle, US interest rates strategist at Barclays, echoed this sentiment, noting that finance markets are “not out of the woods”.

Some analysts and policymakers say the Fed may need to initiate direct asset purchases if pressures do not ease.

Last week, Dallas Fed President Lori Logan, a former member of the New York Fed’s markets group, noted that “if the recent rise in repo rates turns out to be anything but temporary, the Fed in my view will need to start buying assets.”

The debate over whether the central bank needs to move to fixed funding markets comes at a time when many analysts say it is on the verge of pulling a lot of money from the financial system as a result of three years of quantitative tightening.

When this happens, banks’ cash reserve levels could fall into risky territory.

“One could argue that we are not in a reserve-abundant environment anymore, and that these events could continue to happen…The Fed would be wise to consider what other tools it has in its back pockets,” Dunn said.

The Fed’s QT program has occurred alongside record Treasury sales, enhancing liquidity pressures. This is because the big banks that act as guarantors of government debt absorb issues that investors do not buy. These traders turn to the repo market to fund these purchases in an attempt to avoid tying up their own funds.

“Such aggressive bond issuance is high by historical standards and risks sapping demand for Treasuries from traditional investors,” said Megan Sweber, interest rate strategist at Bank of America.

“In order to better balance supply and demand for bills, we believe a passive buyer will likely be needed for a long period: the Fed.”