Repo Rates Rise Despite Fed's Efforts to Curb Volatility

Repo rates in the overnight funding market have continued to rise, even after the Federal Reserve adjusted some of its tools in an effort to rein in volatility. The Secured Overnight Financing Rate (SOFR), an important one-day lending benchmark linked to activity in the repurchase agreement market, jumped to 4.40% as of Dec. 24 from 4.31%, according to New York Fed data released Thursday. This increase aligns with the interest on reserve balances rate of 4.40%, indicating that bank year-end balance-sheet constraints are starting to drive up the cost of overnight funding (Reuters, Dec. 24, 2024).

The Federal Reserve Bank of New York's Roberto Perli stated that while there is considerable evidence that reserve supply is not scarce, recent pressures in the overnight funding markets around key regulatory reporting dates and Treasury settlements suggest that bank reserves may be approaching a level of scarcity (Bloomberg, Sep. 27, 2024). This scarcity, combined with year-end balance-sheet constraints, has contributed to the rise in repo rates.

The Fed's Standing Repo Facility (SRF) and other standing liquidity facilities act as backstops, helping to contain upward pressure in rates and supporting smooth market functioning. However, persistent pressure in one money market segment can often be transferred to other segments, indicating that rate control depends on the smooth functioning of all major segments of money markets (Speech by the Manager of the System Open Market Account, Dec. 27, 2024).

The Fed has taken steps to address the rising repo rates, including adjusting the rate differential between fed funds and the overnight reverse repo facility (ON RRP) to keep the funds rate in the desired range or navigate periods of near-zero rates. Harmonizing the spread now could help the central bank gain some flexibility as it sheds bond holdings, referred to as quantitative tightening, or QT. This adjustment is expected to encourage people to find alternatives to parking money at the Fed and likely lower money market rates as well (Reuters, Dec. 24, 2024).

However, the Fed's quantitative tightening (QT) policy, which involves reducing its balance sheet by allowing some of its Treasury and mortgage-backed securities holdings to expire and not be replaced, has had an impact on repo rates. As the Fed has shrunk its balance sheet from a record $9 trillion in the summer of 2022 to $7 trillion, the reverse repo facility (ON RRP), which takes in cash primarily from money market funds, has contracted. This has led to a decrease in the usage of the ON RRP facility, which was always meant to be temporary. However, the facility has been sticky, and some money funds have challenges placing cash elsewhere, making it less attractive to park cash at the Fed (Reuters, Dec. 24, 2024).

In the future, the Fed may face challenges in getting cash out of the ONRRP and ending QT, given potential "substantial shifts" in government cash management, which could mask the effects of ongoing balance sheet runoff on money market conditions and pose challenges in assessing reserve conditions. Banks surveyed by the New York Fed ahead of the Fed's November policy meeting expected QT to end in May, with the Fed then keeping its balance sheet steady at around $6.4 trillion. However, the weeks ahead will be unsettled for money markets, adding to the difficulty in predicting an end to QT (Reuters, Dec. 24, 2024).

To address these challenges, the Fed is considering a technical adjustment to the offering rate on the ON RRP facility, known as the RRP, so that it's equal to the bottom of the target range for the federal funds rate. Lowering the ON RRP offering rate by five basis points would align it with the bottom of the target range for the federal funds rate and would probably put some downward pressure on other money market rates. This change could help the central bank gain some flexibility as it sheds bond holdings and encourage people to find alternatives to parking money at the Fed (Reuters, Dec. 24, 2024).

In conclusion, repo rates have continued to rise despite the Fed's efforts to curb volatility through adjustments to its administered rates and tools. The rise in repo rates can be attributed to year-end balance-sheet constraints, potential scarcity of bank reserves, and the impact of quantitative tightening on the money market. The Fed is considering further adjustments to its administered rates to address these challenges and regain control over money market rates.