Liquidity concerns intensify, traders heavily bet on the federal funds rate spread

According to the Zhitong Finance APP, as concerns about liquidity in the market continue to rise, traders are flooding into a segment of the U.S. interest rate futures market at record levels, betting that if the Federal Reserve takes action to alleviate financing pressures in the money market, the spread between overnight loan rates will change.

The Chicago Mercantile Exchange Group (CME Group) confirmed in a post on platform X that the trading volume of futures spreads related to the Secured Overnight Financing Rate (SOFR) and the federal funds rate surged to a historical peak on Wednesday. The group further stated on Thursday that the total trading volume of one-month SOFR-federal funds basis trades exceeded 400,000 futures contracts.

SOFR (Secured Overnight Financing Rate) is a benchmark for overnight cash borrowing rates secured by U.S. Treasury securities, with the latest fixing rate at 4.27% as of October 29. The effective federal funds rate is the weighted average of overnight borrowing rates between banks, with the latest fixing rate at 4.12%, which is 15 basis points lower than SOFR.

The intense betting by traders on this spread reflects an increasing market focus on how the spread between the two benchmark rates will change if the Federal Reserve adjusts its managed rates after stopping balance sheet reduction, with the risk exposure of related bets continuously expanding.

One of the key factors influencing spread changes is whether the Federal Reserve will take measures to address fluctuations in the overnight repurchase market. The overnight repurchase market is an important component of the financial system's "infrastructure" and a potential "barometer" of financing stress, with the SOFR rate calculated based on repurchase market data.

In recent weeks, signals of market pressure have been accumulating, leading some Wall Street strategists to believe that the Federal Reserve will take action to improve market liquidity. However, on Wednesday, Federal Reserve Chairman Jerome Powell did not announce any measures to alleviate liquidity pressures, nor did he hint at any future actions.

On Wednesday, disappointment triggered a sell-off. The Federal Reserve's decision not to take direct action on repurchase rates initially disappointed the market, leading to a new wave of activity in SOFR-federal funds basis trading—especially in the November contracts, where trading volume of futures spreads exceeded 200,000 contracts. The trading flow was primarily focused on "selling SOFR futures and buying federal funds futures," causing the spread to drop to a cycle low of 11.5 basis points, resulting in an inverted state.

On Thursday, traders repositioned for a policy shift. Traders began to repurchase the November contracts spread they had previously sold, partly to position themselves ahead of a potential shift in the Federal Reserve's stance in the coming weeks, and partly to reduce risk amid ongoing financing pressures.

Wall Street strategists expect liquidity pressures to persist into November, driven mainly by two factors: first, the Federal Reserve's balance sheet reduction will continue for another month, leading to a further decline in bank reserves; second, the U.S. Treasury will issue more short-term government bonds, absorbing a large amount of cash from the market