The Federal Reserve Board of Governors' balance sheet reduction is pushing up short-term borrowing costs.

The short-term borrowing costs in the United States are rising again, and traders are closely watching this situation. According to data, the surge in short-term borrowing costs is due to the Federal Reserve Board of Governors starting to reduce its balance sheet and the Treasury Department strengthening cash recovery.

These movements are siphoning liquidity from the financial markets that have been flooded with low-cost funds for nearly the last 20 years. Currently, the market system is under tension, the repo market is showing abnormal movements, and the overnight interest rates are no longer approaching the Federal Reserve Board of Governors' target.

In early September, the overnight cash rate, primarily used for mutual borrowing between banks and asset management companies, surged beyond the interest rate range set by the Federal Reserve Board of Governors and is currently maintaining a high level.

At the same time, the usage of reverse repurchase agreements, one of the main tools for central banks to absorb excess cash, has significantly decreased, reaching a four-year low. This indicates a problem where cash reserves in money market funds are not as abundant as they used to be.

If these funds are depleted, there is a possibility that the turmoil of 2019 may be reproduced. At that time, the repo rate suddenly surged, and the Federal Reserve Board of Governors was forced to inject $500 billion to keep the market functioning.

Continued Cash Outflows and High Interest Rates, Traders' Preparedness

Mark Cabana, the U.S. bank's U.S. interest rate strategy chief, stated that this is not a temporary phenomenon. “We are seeing changes in the funding level,” he said, adding, “Money funds no longer have surplus cash to allocate to RRP (Reverse Repurchase Program).” Mark expects that a comprehensive disaster like September 2019 will not happen again, but he believes that high overnight rates will continue.

Liquidity is already under pressure. The situation may worsen further next week. Traders are preparing for auction settlements and corporate tax payments, which will further siphon off cash from the system. Bank deposits to the Federal Reserve Board of Governors, their safety net, are also decreasing.

Currently, the repo rate backed by U.S. Treasury securities is fluctuating near the Federal Reserve Board of Governors' interest on reserve balances (IORB). Since early September, the average difference between the repo rate and the federal funds rate has reached 11.5 basis points.

In July and August, this gap was kept below 10. At that time, traders were just moving funds between repos and government bonds. This strategy no longer works.

These rising costs are leading to an overall rise in short-term borrowing costs. Ultimately, this will have a significant impact on businesses, consumers, and everyone who needs quick access to funding. Therefore, even if the Federal Reserve Board of Governors later begins to cut interest rates, the likelihood that these saved funds will benefit everyone is low, as the financial markets are already very tight.

If funding runs dry, the entire $29 trillion U.S. Treasury market could be affected. Hedge funds that rely on the spread between U.S. Treasuries and derivatives will be the first to take a hit. These trades are very fragile and require stable funding.

Continuation of Quantitative Tightening Policy and Tension of FRB Tools

Wells Fargo strategist Angelo Manolatos stated, “The financial markets are providing real-time data.” He warns that if interest rates continue to approach the IORB, Federal Reserve officials may conclude that they are nearing the lower bound of reserves.

Currently, bank deposits to the Federal Reserve Board of Governors are decreasing. Christopher Waller, one of the governors of the Federal Reserve, recently estimated the minimum safety level, known as the “adequate” level, to be around $2.7 trillion.

The Standing Repo Facility (SRF) enables banks and other institutions to exchange U.S. Treasury securities and government agency securities for cash at a fixed interest rate close to the upper limit of the Federal Reserve's policy rate range (currently 4.5%). Usage of this facility surged at the end of June, reaching the highest level since its permanent establishment in mid-2021.

The existence of such safety measures has prevented most traders from panicking. In 2019, the repo rate surged due to tightening reserves and the Federal Reserve Board of Governors' balance sheet reduction. This time, the presence of the SRF is aimed at suppressing the repo rate and preventing a market collapse.

Some Federal Reserve officials, including Mr. Waller and Dallas Fed's Lorie Logan, acknowledge that they are paying attention to the pressures in the money market. However, no one is saying that there is a need to halt the quantitative tightening policy early. This only amplifies concerns that these high funding costs will persist as the Treasury resumes large-scale bond issuance in October.