Rates spark: A frustrated Fed on liquidity watch

We're not overly concerned about tightness in US repo of late. It does show that the liquidity environment is uneven. It appears that eligible standing repo participants don't need it, as there are minimal asks for it. Frustrating for the Fed, as it sees the effective funds rate creeping higher. T-bill buying from 1 December is far from perfect. But it will do.

The plumbing shows liquidity pressures, and only clunck solutions

The Federal Reserve will be watching the latest nudge higher in the effective funds rate with a degree of frustration. It's now just 2bp below the rate paid on excess reserves (3.90%). Most banks will post at the excess reserves window. Players that can't will make do by posting at the Fed funds window. The other alternative is the Fed's reverse repo rate, which sits on the Fed funds rate floor. That rate has become broadly inconsequential of late, as, at 3.75%, it sits well below other alternatives.

The significant dynamic currently is the tightness in market repo. The SOFR rate, effectively the general collateral rate, had edged up to 4%, and so, well above the rate on excess reserves. This has been acting to coax the effective funds rate higher, as liquidity is attracted away from this bucket into market repo. Hence, the ratchet up in the effective funds rate. It's mild. But it's not a great look, as the Fed would prefer for this rate to be steady and boring. Movements in it is a signal that there is a degree of tension between the various liquidity buckets.

Meanwhile, the Federal Reserve is standing ready to provide liquidity to eligible participants through its standing repo facility, but there has not been much demand for such liquidity. Presumably, this is so as the primary dealers and approved depository institutions are not the ones feeling the liquidity squeeze. But at the same time, these eligible participants have the capacity to level out liquidity needs across the marketplace. Hence, the Fed's likely frustration, as they are standing ready to supply liquidity, the optics suggest that there is a liquidity need, but there is minimal takedown of it.

We continue to view bank reserves as ample, but the easiest way for the Fed to impact liquidity conditions now is to buy T-bills and thereby coax an increase in bank reserves. It's a blunt means to solving the perception of liquidity tightness though. Far better to fast track the mooted loosening in the Supplementary Liquidity Ratio requirements, thereby allowing the bigger banks to deploy more balance sheet. As it is, the effective funds rate is prone to trading above the rate on excess reserves. This would not technically be an issue. Banks would then switch into the funds rate window to prevent a really material overshoot.

Overall, we view all of this as manageable and not a cause for concern. But it is something that the Fed will choose to address, mostly by buying T-bills in excess of the MBS roll-offs (starting on 1 December). In the meantime, there has been some evidence of a calming in repo in the past 24 hours, which should help, and could help ease the effective funds rate too, if sustained.

Beyond the ultra front end, things are far more tranquil

Despite the plumbing issues, there's not been a meaningful effect on market rates maturing beyond year-end. And in bonds, the 2yr yield has been a picture of stability, as has the 10yr yield. The 2yr is trading with very little consequence being attached to whether the Fed cuts in December or not, on the theory that the Fed is on a cutting agenda anyway, and will get the funds rate down towards 3% regardless. The theory is, if there is a hold in December, it's only a temporary halt. The persistent richness attached to the 5yr on the curve tells the same story.

The 10yr is trading comfortably at above 4.1%, and has been up there ever since Chair Powell cast doubt on a December rate cut. Hard data releases ahead will have the final say, including some tolerance for weak employment data given the supply-side shocks. It suggests some tolerance to weak activity data. The bigger issue is the 3% inflation environment, and the near term prospect for this to drift higher (tariff impacted). The 10yr yield would need a really weak employment report on Thursday to get back below 4%. More likely we will see a mediocre employment number, and for that to leave the 10yr yield thinking about the logic for an edge higher.

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