The Fed's balance sheet cuts are driving short-term borrowing costs higher

Short-term borrowing is getting expensive again in the U.S., and traders aren’t ignoring it. According to data from Bloomberg, the surge started when the Federal Reserve began slicing down its balance sheet while the Treasury ramped up cash collection.

Both are yanking liquidity out of funding markets that’ve been flooded with cheap money for almost two decades. Now the system is tight, the repo market’s acting weird, and overnight rates are no longer sticking to the Fed’s target.

At the start of September, rates for overnight cash, mostly used by banks and asset managers to lend to each other, jumped over the Fed’s own range. And they’re still elevated.

At the same time, one of the central bank’s main tools to absorb excess cash, the reverse repo facility, is getting way less traffic. It’s now at a four-year low. That’s a problem because it shows money market funds aren’t as cash-rich as they used to be.

And if they’re drying up, it could mean a repeat of the chaos from 2019, when the repo rate suddenly exploded and the Fed had to drop $500 billion just to keep markets breathing.

Traders prepare as cash leaves and rates stay high

Mark Cabana, the head of U.S. interest rate strategy at Bank of America, said this isn’t just a blip. “We are seeing a level shift in funding,” he said, adding that “money funds no longer have excess cash to deploy to the RRP.” Mark doesn’t expect another full-blown September 2019 disaster, but he thinks the high overnight rates are here to stay.

Liquidity’s already under pressure. Next week could get worse. Traders are bracing for auction settlements and corporate tax payments to suck even more cash out of the system. The balances that banks keep with the Fed, their safety net, have been falling too.

Repo rates backed by U.S. Treasuries are now hovering around the Fed’s interest on reserve balances (IORB). Since early September, the gap between repo and fed funds has hit 11.5 basis points on average.

In July and August, that gap stayed under 10. Back then, traders were just moving money around between repo and T-bills. That tactic’s not cutting it now.

These elevated costs raise short-term borrowing prices across the board. That ends up slamming companies, consumers, and anyone who needs quick financing. So even if the Fed starts cutting rates later, those savings might not trickle down because funding markets are already too tight.

If funding dries up, the entire $29 trillion Treasury market could feel it. Hedge funds relying on price gaps between Treasuries and derivatives would get hit first. Those are fragile trades, and they need smooth funding.

Fed tools strain as quantitative tightening continues

Wells Fargo strategist Angelo Manolatos said, “The funding markets give us a real-time read.” He warned that if rates keep hugging the IORB, Fed officials might decide they’re near the bottom limit for reserves.

Right now, banks have about $3.15 trillion parked with the central bank. Christopher Waller, one of the Fed governors, recently estimated that the minimum safe level, called “ample,” is around $2.7 trillion.

The Standing Repo Facility (SRF) lets banks and others trade Treasuries or agency debt for cash at a set rate near the top of the Fed’s policy range, currently 4.5%. Usage of that facility spiked at the end of June, hitting its highest point since it was made permanent in mid-2021.

That backstop is why most traders aren’t panicking yet. In 2019, the repo rate blew out because reserves were tight and the Fed was already cutting its balance sheet. This time, the SRF exists to cap repo rates and keep the market from snapping.

Some Fed officials, like Waller and Dallas Fed President Lorie Logan, have admitted they’re watching the stress in money markets. But no one’s saying QT needs to stop early. That’s just feeding the belief that as Treasury restarts heavy bill issuance in October, these high funding costs will stick around.

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