SOFR Surges 9bps as Treasury Auctions, Tax Payments Tighten Liquidity

In the United States, the financial system's key short-term interest rates have surged to their highest levels this year, driven by the dual impact of Treasury auctions and corporate quarterly tax payments. This has led to a tightening of market liquidity, with the overnight benchmark rate, the Secured Overnight Financing Rate (SOFR), rising from 4.42% on September 14 to 4.51% on September 15. This marks the largest single-day increase since December 31.

The current situation is exacerbated by the U.S. Treasury's efforts to rebuild its cash reserves and the Federal Reserve's ongoing reduction of its balance sheet. These factors have contributed to a steady increase in overnight financing rates between banks and asset management companies. Concurrently, the usage of the Federal Reserve's overnight lending tool, which is often seen as an indicator of excess liquidity in the financing market, has dropped to its lowest level in four years.

This rise in rates has widened the spread between SOFR and the effective federal funds rate, which is expected to be lowered by 25 basis points by policymakers on Wednesday. The spread has reached 18 basis points, the highest level since December 26. Additionally, SOFR is currently 11 basis points higher than the interest rate paid by the Federal Reserve for bank reserves, which is currently at 4.40%.

Despite the rising rates, the overall condition of the financing market remains stable. However, there is a growing concern about the sustainability of the Federal Reserve's quantitative tightening plan, which involves reducing its balance sheet. This plan, if continued, could potentially weaken the effectiveness of the Federal Reserve's policy to lower its target interest rate, which the market is currently anticipating.

Since 2022, the Federal Reserve has been reducing its balance sheet to reverse the trillions of dollars in asset purchases made to stimulate the economy post-pandemic. The goal is to bring the level of bank reserves held at the central bank down to a "sufficient minimum level" that can prevent market disruptions. As of now, the reserve balance stands at approximately 3.15 trillion dollars, nearing the estimated sufficient minimum level of 2.7 trillion dollars.

Following the summer debt ceiling agreement, the U.S. government has increased the issuance of short-term Treasury securities, leading to a continuous outflow of funds from the Federal Reserve's reverse repurchase agreement tool. This has put additional pressure on the benchmark interest rate. However, market participants expect that the rate pressure will ease temporarily before the end of the quarter due to the expiration of two long-term cash management bills on September 16, which are expected to release 50 billion dollars in net funds. Additionally, government-supported enterprises are expected to inject liquidity into the market over the coming days.

Despite the current challenges, the market is expected to have a brief respite in the next two weeks as funds are repatriated. This will allow the market to focus on managing liquidity at the end of the quarter. The recent drop in the early morning repurchase rate is seen as a positive sign, indicating that the market is stabilizing. However, the long-term impact of the Federal Reserve's quantitative tightening plan remains a concern, as it could potentially limit the central bank's ability to lower interest rates in the future.