Author: Alex Harris
Article: Original article
Publication date: Tuesday, December 6, 2022
Short-term dollar borrowing costs are increasing not just because of the expectations that the Fed will continue to hike rates. Consequences of the balance-sheet reduction have finally started affecting the situation, and there might be more to come.
The Fed’s rate hiking has surely been the major force driving the rise of interest rates in the front-end market: the fed funds target rose by 375 basis points, and if traders are right, there are still 100 points to go before it reaches its peak. Besides that, some “small but significant shifts” are now currently happening in money markets, according to Mark Cabana and Katie Craig, analysts at Bank of America Corp.
As they said, the change is getting more and more notable in the repo market that provides one-day loans collateralized by Treasuries. Repo is an important element of money markets, and it is gaining more significance since it serves as a base for Secured Overnight Financing Rate. Said rate is a benchmark preferred by interbank money participants, and it has already become a key component for determining rates on loans.
The repo rates are now higher when compared to Fed’s rates due to more demand for borrowing in the market. The main reason for this is that banks and other companies have big amount of Treasuries on balance sheets, but less cash they are trying to borrow.
Demand for repo trades declined when the Fed was buying bonds to keep the rates low. The financial system was flooded with cash, while there was less supply of available bonds, which caused a decline of repo rates. The process was still going even at the initial stages of the quantitative tightening (QT) that started earlier this year due to plenty of cash and persistent shortage of available Treasury bonds.
The mentioned facts were frustrating for money-market funds and others that can invest only in the shortest-dated assets, such as Treasury bills, thus forcing them to put more than $2 trillion on reverse repo at the Fed.
But now some of those funds are taking money out of that mechanism because they can gain more in the repo market. In late November, the SOFR benchmark – which is an equivalent to the market repo rate – was registered at the level of 3.82%, which is 2 basis points more than of the Fed’s reverse repo. This is the biggest gap since March 2021.
A couple of basis points might seem to be insignificant, but it means a lot to banks and other entities after long years of relatively low costs, especially when compared to the present situation. A fact that the rates are rising – and might go even higher – is probably even more important.
Analysts at Bank of America said that the increase of repo rates was likely caused by a jump in the amount of Treasury bonds the securities dealers have. Such a tendency, in their opinion, will continue pressuring the rates to go higher.
As it was written by Cabana and Craig, collateral had started to overwhelm cash, and this process won’t stop until QT is ended. They stated that the shift was expected for a long time, and now some clear signs of it are evident.
The process will probably continue in 2023, as the Fed keeps reducing its bond holdings, thus leading to an additional drain in liquidity from the system by $1 trillion, as the analysts said. At the same time, the supply of Treasury bills is suggested to increase.
Forecast: the dollar index is likely to rebound upwards