MNI: Fed Patient On SOFR, Seen Boosting Reverse Repo- Ex-Staff

The Federal Reserve should not overreact to recent weakness in some money market rates and will leave the rates it pays on bank reserves and reverse repos steady, but could increase its overnight reverse repo facility per counterparty limit as soon as this month, former central bank staff told MNI.

The benchmark fed funds rate is rock steady at just 8bps above the bottom of the target range of 1.5% to 1.75%, but there has been weakness in the secured overnight financing rate (SOFR) and other repo reference rates in recent weeks, driven by an underlying cash and collateral imbalance. Fed liquidity has increased USD2.5 trillion and Treasury and other money market issuers have slashed supply by almost USD1.5 trillion since mid-2020.

Weakness has appeared in money market rates since the Fed started raising rates from zero. But the leaks of overnight rates printing below ON RRP grew during June and the the first percentile of SOFR transactions recently printed 75bp below the target band.

"I do think that we are at or very recently past the peak of that imbalance," said Mark Cabana, formerly of the markets group at the New York Fed, who expects the Fed's QT will drain cash and add collateral to the banking system and US deficits will support a slow increase in debt supply.

Still, the Fed has signaled a potential increase in the per-institution limit on participation at its overnight reverse repo facility. The Fed upped its limit in March 2021 from USD30 billion to USD80 billion and again to USD160 billion in September, and is generally ready to provide unlimited support to the market, even if the change does not necessarily come at the July FOMC meeting, former staff say.

Flows into the facility have risen to a record over USD2.3 trillion. "I expect it to go up to USD3 trillion," said Joseph Wang, who spent five years on the New York Fed's markets desk. "Bill issuance continues to decline and the Fed is going to increase rates very rapidly, maybe around 3% by the end of the year. That's going to make money market funds a lot more attractive and they have nowhere to go but invest in the RRP."

SPECIALS

"What's going on now with the average repo rates being below the RRP rates have to do with some form of market segmentation," said Quentin Vandeweyer, an outside Fed adviser who worked in the ECB's Research Directorate. "Access to the RRP in theory is supposed to provide a floor for repo rates. But in practice, access is not complete."

Another factor for low settings of SOFR has been increased front-end specialness, which is when lenders are willing to earn lower rates of return for obtaining a specific issue of collateral. Because of how the SOFR rate is calculated, increased breadth of specialness can mechanically cause SOFR to set lower versus what would have otherwise been the case.

"Interest rates are going to go higher, and that means there's more specials activities, and that kind of makes it so that sometimes specials leaks into SOFR pushing it down a little bit as well," Wang said.

REPUTATION

But the Fed also risks loss of confidence in SOFR, its preferred LIBOR alternative. "We do worry that if we see SOFR set low outside the target band, that it does run the risk of causing investors to really potentially question the index and how it is expected to behave across a variety of economic and financial regimes," said Cabana, now at Bank of America.

New York Fed President John Williams said Monday at an event: "SOFR is a very deep market, it's a very liquid market. It's sending a very clear signal of what market conditions are there. To me, everything is working."