U.S. liquidity indicators show signs of "tightening" again—Is the market forcing the Federal Reserve to "restart QE"?

After a brief stabilization, the US short-term financing market is once again showing signs of tightening liquidity, raising doubts in the market about the effectiveness of the Federal Reserve’s recent interventions. The rebound in key interest rate indicators is fueling speculation that the Fed may be forced to expand its balance sheet again — a move some market participants interpret as a new round of "Quantitative Easing" (QE).

Most recently, the Secured Overnight Financing Rate (SOFR), a benchmark for key funding costs, has risen significantly again, widening its spread against the Interest On Reserve rate (IOR) to 8 basis points. This indicates that the previously eased financing environment has grown tense once again.

This change comes after the Federal Reserve, aiming to ease market pressure, ended Quantitative Tightening (QT) two months early at the end of October. The market’s latest response suggests that bank system reserves may be sliding toward “scarcity,” putting further pressure on the Fed to act. Market participants are closely watching to see if the Fed announces the start of “reserve management purchases” to inject additional liquidity into the financial system.

Even though the Fed’s earlier decision to end QT at one point alleviated the worst repo market freeze since the outbreak of COVID-19 and temporarily restored market stability, the current tension indicates that underlying liquidity challenges may be more persistent than expected.

SOFR Sounds Alarm Again

After the Fed announced the end of QT in late October, SOFR briefly retreated, nearly matching the reserve rate, but the recent surge has broken that calm. The expanding spread between SOFR and IOR is a key signal measuring stress in the money market.

According to Goldman Sachs’ repo trading desk analysis, not only has SOFR risen, but tri-party repo rates have also recently rebounded to about 0.8 basis points above the reserve rate. Based on the framework laid out by Bank of America analyst Mark Cabana, rates above the IOR typically indicate bank reserves have moved out of “ample” or even “abundant” territory and into “scarce” territory.

“Reserves No Longer Ample”

On the reasons behind rising financing rates, Goldman Sachs FICC trader Chris Horvatin shared his observations in a recent report. He noted that recent statements by Fed officials were rather "confusing," saying reserves are no longer “abundant,” but still “slightly above ample levels.”

Horvatin interprets these remarks as implying that “reserve management purchases” will be the next step in the Fed’s balance sheet normalization. This means the Fed’s balance sheet may soon begin to grow again. This view aligns with that of Bank of America's Mark Cabana, who had accurately predicted the Fed would end QT early and suggested the Fed should buy short-term Treasuries at a pace of $75-100 billion a month to supplement reserves.

The Fed Eyes Two Key Indicators

Chris Horvatin believes the timing for the Fed to re-expand its balance sheet (the SOMA portfolio) will depend on several factors, with two being especially critical.

The first is the relationship between the Effective Federal Funds Rate (EFFR) and the Interest on Reserve Balances (IORB). Recalling the situation from 2018 to 2019, when EFFR persistently exceeded IORB, the Fed decided to slow QT. Horvatin notes that the market currently shows distinct signs of stress, and expects the spread between EFFR and IORB may narrow further by year-end.

The second is the ongoing usage of the Standing Repo Facility (SRF). Use of the SRF is viewed as a clear indicator that reserves are at a scarce level. According to comments by New York Fed President Williams and officials Lorie Logan, Hammack, and Perli, the Federal Open Market Committee (FOMC) clearly wishes to stress test this new tool. Data show that after a brief pause, SRF usage has recently resumed daily operation. Goldman Sachs expects that as dealers optimize their balance sheets before year-end, borrowing needs will increase and SRF usage may rebound further.

The Market Bets on Fed Balance Sheet Expansion

In summary, the current tension in the financing market is the result of multiple factors. These include QT continuing to drain liquidity (set to end officially only on December 1), market expectations that the Fed will soon announce “reserve management purchases,” and the Fed’s stance of letting the SRF tool play a larger role during the transition in reserve levels.

Currently, the level of bank reserves in the US has fallen to a five-year low. The Fed hopes the transition from “abundant” to “scarce” reserves can proceed smoothly, but market signals suggest that this process could be turbulent. At present, the only unresolved question is: Which factor will “explode” first and force the Fed into more decisive action.

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