Is a funding shortage emerging in 2019? Signs of tightening liquidity in the global money market are evident

Signs of tightening are beginning to appear in certain areas of the global money market. Government departments are expanding the scale of debt issuance, pulling market funds out of the financial system. In the United States and the United Kingdom, short-term borrowing rates secured by collateral have risen to multi-year highs. Although the specific triggers vary by country, the market generally shows signs of tightening liquidity.

On Wednesday, the Federal Reserve announced that it would stop reducing its holdings of Treasury securities starting December 1, ending a three-year balance sheet contraction as signs of tightening liquidity have increased. The Bank of England is encouraging financial institutions to borrow cash through its redesigned repo operations to reduce the risk of excessive volatility.

Media analysis indicates that this change represents, to some extent, a "normalization," where central banks are adjusting after years of injecting excessive liquidity into the funding markets through bond purchases. Investors are concerned about the re-emergence of risks, such as the spike in U.S. short-term rates in September 2019, when the Federal Reserve had to inject about $500 billion into the system to calm market turmoil.

ING Groep's senior interest rate strategist Michiel Tukker stated, "The global money market must learn to operate in a world without excess reserves. Although central banks now have various tools to inject liquidity, the key question is whether these funds can truly flow to where they are most needed."

United States

The Federal Reserve's primary liquidity tool—the reverse repo mechanism—has nearly been depleted, and bank reserves are also declining. Following the U.S. government's increase in the debt ceiling during the summer and the continued balance sheet reduction by the Federal Reserve, the result is that interest rates in the money market, or the interbank short-term lending market, have risen and have remained high since early September.

The overnight general collateral repo rate, secured by U.S. Treasuries, reached 4.32% on Friday, exceeding the Federal Reserve's policy rate range of 3.75% to 4%. This phenomenon indicates that dollar liquidity in the financial system is not as strong as it once was, especially after the Federal Reserve reduced its balance sheet by about $2.2 trillion over the past three years.

Benchmark rates related to repo transactions, such as the Secured Overnight Financing Rate (SOFR) and the Tri-Party General Collateral Repo Rate (TGR), have risen above the interest on reserve balances (IORB) that the Federal Reserve pays to banks. Dallas Fed President Logan stated that it is appropriate for the Federal Reserve to maintain money market rates close to or slightly below the IORB level.

Notably, this is the first time since 2019 that these rates have exceeded the Federal Funds Rate target range, excluding month-end or auction settlement periods.

The surge in repo rates has triggered an influx into the Federal Reserve's liquidity tools, some of which are backup measures introduced after the market turmoil in 2019. The Federal Reserve's Standing Repo Facility (SRF) allows eligible institutions to borrow cash against U.S. Treasuries and agency securities, and the usage of this facility has significantly increased in recent weeks. On Friday, a counterparty utilized the first of two daily operations provided by the SRF, borrowing $20.4 billion, marking the highest single-day borrowing amount since the facility was made permanent in 2021

United Kingdom

As the Bank of England continues to reduce its government bond asset portfolio and banks repay low-interest loans issued during the pandemic, the volatility of the pound sterling repurchase rate has intensified. This week, the average overnight repurchase index (a measure of overnight repurchase costs among market participants, cited by the Bank of England) rose to 4.28%, while the Bank of England's key deposit rate stands at 4%.

According to data from WMBA Ltd., this is the largest premium since March 2020, excluding data around quarter-end. This surge reflects that banks have repaid a record £23 billion in loans from the Bank of England, increasing their demand for alternative funding sources.

Banks are compensating for the funding loss caused by loan repayments by utilizing the Bank of England's liquidity tools. On Thursday, banks borrowed a record £98 billion through a one-week repurchase operation, following similarly strong demand in a six-month auction on Tuesday.

Even so, the transition to the Bank of England's so-called "repo-led operational framework" has increased the risk of market turbulence. Barclays strategist Moyeen Islam stated that this week's market volatility indicates that liquidity is exiting the market at an alarming rate.

Europe

In Europe, the financing market remains relatively calm, with core repurchase rates showing almost no signs of pressure. However, signs of tightening liquidity have gradually transmitted to the unsecured lending market.

Short-term euro rates (reflecting the overnight borrowing costs among eurozone banks) have gradually aligned with the European Central Bank's deposit rate. This week, the spread between this rate and the European Central Bank's deposit rate has narrowed to its lowest level since 2021. This reflects an increased demand for cash as excess liquidity in the eurozone financial system diminishes