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Banks tapped the Federal Reserve’s short-term lending facility for more than $15bn over the past two days, in a sign of the liquidity pressures in the repo market that could drive the Fed to stop shrinking its balance sheet.
Banks borrowed $6.75bn on Wednesday and $8.35bn on Thursday from the Fed’s standing repo facility (SRF), the largest amount borrowed over a two-day period since the Covid-19 pandemic.
The SRF was introduced in 2021 as a permanent replacement for emergency repo operations launched by the Fed in the wake of market turmoil two years earlier.
It is intended as a safety valve that helps limit how high borrowing rates in the short-term funding market can go, by allowing banks to borrow cash from the Fed during twice-daily operations in return for collateral such as US Treasury debt.
In normal conditions, the facility is rarely used, because banks can typically borrow at better rates in the repo market than at the SRF. But traders and analysts said that banks were forced to borrow at the Fed because repo lending rates rose above the 4.25 per cent offered.
Settlements of Treasury bills and bonds this week contributed to the strain in lending markets. However, those are regular events that have not had the same kind of effect on the market in recent years.
The jump in repo rates suggests that the Fed’s effort to shrink its balance sheet by shedding Treasury debt — otherwise known as quantitative tightening or QT — is nearing its end, depleting banks’ excess reserves.
The Fed bought billions of dollars of Treasuries after the Covid-19 pandemic, increasing its balance sheet to $9tn and flooding the financial system with cash. Since 2022, the Fed has pulled back, allowing Treasuries and government-backed mortgage securities to mature without buying replacements.
“I think that there are now clear signs that the Fed has likely over-drained liquidity from the system,” said Mark Cabana, head of US rates strategy at Bank of America. “QT will end by the end of the year, but it could end even earlier.”
“This is a loss of control of money markets,” said Cabana.
Officials have signalled quantitative tightening could end as soon as this year. Jay Powell, Fed chair, said on Tuesday that he expected to be halting QT in the “coming months”.
Powell also confirmed that officials would like banks to continue to hold what they describe as “ample reserves” — code for lenders having enough cash that they are not usually reliant on facilities such as the SRF. The Fed’s weekly balance sheet showed lenders held $3tn in reserves at the US central bank.
“Some signs have begun to emerge that liquidity conditions are gradually tightening, including a general firming of repo rates along with more noticeable but temporary pressures on selected dates,” Powell said.
Many on the Federal Open Market Committee, the central bank body that makes decisions on quantitative easing and tightening, want to avoid a repeat of a scenario where liquidity dries up to an extent that they no longer feel they have control over short-term interest rates.
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