Is the Federal Reserve about to intervene in the market? The recent tightening in funding conditions has many wondering if the Fed will soon need to expand its balance sheet, but the timing might be a bit premature. Let's break down why.
Firstly, let's look at the evidence. On December 1st, the Fed's standing repo facility (SRF) saw a significant uptick, with usage reaching $26 billion – the largest daily amount since October 31st. Simultaneously, the tri-party general collateral repo rate (TGCR) climbed to 18 basis points above the interest paid on reserves (IORB). These movements signal a tightening in the funding markets as we approached the year-end. This isn't entirely unexpected, given previous observations.
However, on November 28th, the effective federal funds rate edged up from 4.88% to 4.89%, with TGCR-IORB spreads at 18 basis points. The Fed is clearly sensitive to any upward pressure on repo spreads, as tight liquidity can threaten their control over interest rates.
But here's where it gets controversial... While funding pressures have been concentrated around specific dates (month-ends, quarter-ends), there's a risk of more frequent occurrences, even on ordinary days. This is why the Fed has hinted at eventually resuming balance sheet expansion. As liabilities like currency in circulation grow, reserves dwindle, further tightening the market. The situation has shifted from abundant to merely ample reserves. Reserve management operations will inevitably be part of the Fed's strategy, though the exact timing is uncertain.
Exhibit #1 highlights the SRF's daily usage over the past six months, demonstrating increased utilization during periods of funding stress. The Fed would likely prefer more frequent and larger SRF usage, reducing the need for open market operations. However, this shift presents a communications challenge, as the Fed must clarify that these operations are for reserve management, not a return to quantitative easing. The SRF's appeal is also hampered by internal and executive stigma, along with a lack of central clearing.
Considering the upcoming FOMC meeting, the question arises whether the Fed will announce reserve management operations. The author believes it's unlikely so soon. There has been limited specific guidance, and funding market strains are still largely date-specific. It is expected that these operations will commence in early 2026 as funding markets gradually tighten further.
Supplementary Leverage Ratio Reform: A Game Changer?
At the end of November, regulators approved changes to the enhanced supplementary leverage ratio (eSLR) for major U.S. banks, adjusting capital requirements for G-SIBs. The primary goal was to encourage banks to engage in low-risk activities, such as intermediating U.S. Treasury markets. This reform, introduced after the 2008 GFC, aimed to boost dealers' capacity to hold more USTs, potentially lowering yields and improving their participation in the Treasury market.
And this is the part most people miss... The author is skeptical that yields will significantly decrease. The reform has been anticipated since the election, and dealers already hold substantial USTs. Exhibit #2 indicates that dealer holdings of UST coupons are near record highs in absolute terms, similar to levels seen in 2018. There may be room for growth, but it's limited.
Exhibit #3 reveals that swap spreads, through which other holders of long-duration USTs hedge rate risk, are likely to widen (become less negative). This trend has already begun, first when the reform was proposed and then as its adoption became more probable.
By freeing up balance sheet capacity for banks, especially G-SIBs' subsidiaries, this reform could encourage them to pursue more profitable activities like lending rather than increasing Treasury holdings. Holding more USTs could also increase interest rate risk, potentially adding instability during stress events, even if it could help during dislocations.
What do you think? Will the Fed's actions have the intended effect? Do you foresee any unintended consequences from these regulatory changes? Share your thoughts in the comments below!
