2019 Funding Shortage Emerging? Signs of Tightening Global Money Market Liquidity Appear
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Certain sectors of the global money markets are beginning to show signs of strain. Government departments are expanding their debt issuance, drawing market funds away from the financial system. In the US and UK, short-term lending rates with collateral have risen to multi-year highs. Although the specific causes differ among countries, markets are generally showing signals of tightening liquidity.
On Wednesday, the Federal Reserve announced that starting from December 1, it would stop reducing its holdings of US Treasury bonds, ending a three-year balance sheet contraction due to increasing signs of liquidity tension. The Bank of England is encouraging financial institutions to borrow cash through its redesigned repo operation channels to reduce the risk of excessive market volatility.
Media analysis points out that this change partly represents a “normalization,” that is, a pullback after years of central bank asset purchases injected excessive liquidity into funding markets. Investors are worried about the reemergence of risks, such as the September 2019 spike in US short-term interest rates—when the Fed had to inject about $500 billion into the system to calm market turbulence.
Michiel Tukker, Senior Rates Strategist at ING, said: “Global money markets must learn to operate in a world without excess reserves. Although central banks now have various tools for injecting liquidity, the key question is whether these funds can truly flow to where they are most needed.”
United States
The Fed's main liquidity tool—the reverse repo facility—has been almost emptied, and bank reserves are also declining. After the US government raised its debt ceiling in the summer and rebuilt its cash reserves, all while the Fed continued its balance sheet reduction, the result is that the money market—i.e., the interbank short-term lending market—has seen interest rates remain elevated since early September.
The overnight general collateral repo rate, backed by US Treasuries, reached as high as 4.32% on Friday, exceeding the Fed’s policy rate target range of 3.75% to 4%. This phenomenon indicates that dollar liquidity in the financial system is not as strong as it used to be, especially after the Fed has reduced its balance sheet by about $2.2 trillion over the past three years.
Benchmark rates linked to repo transactions, such as the Secured Overnight Financing Rate (SOFR) and the Tri-party General Collateral Repo Rate (TGR), have all surpassed the Fed’s interest rate paid to banks on reserves, known as the Interest on Reserve Balances (IORB). Dallas Fed President Logan stated that it is appropriate for the Fed to keep money market rates near or slightly below the IORB level.
Notably, this is the first time since 2019, excluding month-ends or auction settlement periods, that these interest rates have broken through the Fed's federal funds target range.
The surge in repo rates has triggered an influx into the Fed’s liquidity tools, some of which were introduced as backstops after the 2019 market turbulences. The Fed’s Standing Repo Facility (SRF) allows eligible institutions to borrow cash against US Treasuries and agency securities collateral; usage of this tool has risen sharply in recent weeks. On Friday, counterparties used the first of two daily SRF operations to borrow $20.4 billion, the highest single-day amount since the permanent establishment of the facility in 2021.
United Kingdom
As the Bank of England continues to shrink its holdings of UK government bonds and banks repay low-interest loans issued during the pandemic, the volatility of sterling repo rates has increased. This week, the sterling overnight repo index average (a measure of overnight repo costs among market participants, quoted by the BOE) rose to 4.28%, while the BOE’s key deposit rate is 4%.
According to data from WMBA Ltd., this is the highest premium since March 2020, except around quarter-end. The surge reflects banks’ repayment of a record £23 billion in BOE loans, which increased their need for other funding sources.
Banks are compensating for the funding loss caused by loan repayments by using BOE liquidity tools. On Thursday, banks borrowed a record £98 billion in a weekly repo operation, following similarly strong demand in a six-month auction on Tuesday.
Even so, the transition to the BOE’s so-called “repo-centric operating framework” has also increased the risk of market disruptions. Barclays strategist Moyeen Islam said that this week’s market swings show that liquidity is flowing out of the market at an alarming rate.
Europe
In Europe, the funding markets remain relatively calm, with core repo rates showing almost no signs of stress. However, signals of tightening liquidity have gradually spread to the unsecured lending market.
The euro short-term rate (reflecting the cost of overnight bank borrowing in the eurozone) has gradually converged with the ECB’s deposit rate. This week, the spread between this rate and the ECB’s deposit rate fell to its lowest level since 2021. This reflects growing demand for cash as excess liquidity in the eurozone financial system decreases.
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