The Federal Reserve’s balance sheet is taking center stage as Wall Street navigates through year-end volatility in overnight funding markets. As attention shifts away from the recent market fluctuations, focus intensifies on the duration the Federal Reserve can sustain its balance sheet unwinding without triggering further disruptions. Traders closely examine the Fed’s overnight reverse repurchase agreement facility (RRP), where eligible counterparties park excess cash. Withdrawals from this facility, driven by the pursuit of higher yields elsewhere, are expected to escalate repo market volatility as the RRP facility approaches depletion.
Recent gyrations in benchmarks like the Secured Overnight Financing Rate (SOFR), reaching a record high last week, hint at potential future volatility. Short-term normalization in rates on overnight repurchase agreements, collateralized by government debt, is anticipated this week following Treasury auctions and maturity of year-end term funding positions. As of December 29, SOFR, connected to repo transactions, fixed at 5.38%, down from its all-time high of 5.40%, according to New York Fed data.
Analysts caution that recent rate fluctuations may be a prelude to more severe and frequent disruptions. If the Federal Reserve continues shrinking its balance sheet until the RRP facility is emptied, SOFR’s day-to-day pattern could resemble the pre-2020 experience rather than the stability seen in recent quarters, notes Wrightson ICAP economist Lou Crandall.
On Tuesday, 78 counterparties withdrew $313.6 billion from the RRP facility, marking the third-largest start-of-year outflow since its introduction in 2013. Balances at the facility plummeted by nearly $1.4 trillion until the last week of the year, influenced by a surge in Treasury bill issuance and the conclusion of interest rate hikes by the monetary authority.
Wall Street strategists estimate complete depletion of balances at the RRP facility by the end of the second quarter. This projection raises the possibility of the central bank halting quantitative tightening, especially if bank reserves turn out to be scarcer than anticipated. Crandall suggests the Fed might need to cease balance sheet runoff before the RRP facility is entirely drained, allowing surplus cash in the facility to be redeployed into the repo market in case of funding market spikes.
In summary, the evolving dynamics of the Fed’s balance sheet and the RRP facility’s depletion are key considerations for market participants, with potential implications for repo market stability and interest rate movements.
