(Bloomberg) -- Mounting pressures in the repurchase agreements market could eventually pull the fed funds rate higher, according to Federal Reserve Bank of New York’s Roberto Perli.
But so far, pressures in the repo market don’t appear to be close to the point they would start affecting the Fed’s benchmark rate, which means there’s still room for policymakers to continue shrinking the balance sheet, Perli said Thursday at the New York Fed’s 10th annual US Treasury Market Conference.
The share of repo transactions that are priced at or above the interest on reserve balances rate — or IORB, which is currently 4.9% — “has increased notably since the spring,” Perli said.
While the gap between the fed funds and IORB has long been the key indicator of reserve scarcity in the financial system, Perli, who oversees the central bank’s portfolio of assets, said a stable spread doesn’t necessarily guarantee “that all is quiet in money markets.”
In May, Perli first laid out metrics that officials are watching to determine the point at which bank reserves start to become scarce — and the Fed’s balance-sheet unwind, known as quantitative tightening, likely has to stop.
Those indicators include the federal funds rate and balances at the reverse repo facility, domestic institutions’ borrowing in the fed funds market, the share of outgoing interbank payments after 5 p.m. New York time and intraday overdrafts by banks, as well as the share of repo transactions above IORB.
The repo market served as a leading indicator of pressures developing in the reserves market back in 2018 but “there is no guarantee that it will be the same again this time,” Perli said. “My colleagues and I will be monitoring its evolution.”
The Fed has been winding down its holdings since June 2022 gradually increasing the amount of Treasury and mortgage bonds allowed to run off its balance sheet without being reinvested. The central bank’s assets peaked at $95 billion per month, and in June it lowered the sum of Treasuries allowed to roll off to $25 billion from $60 billion.
The Fed amassed the pile of debt as part of economic-stimulus measures during the pandemic. Market participants have been debating how much more the central banks would be able to shrink its $7.1 trillion portfolio of assets before worrisome cracks — similar to those seen in 2019 ahead of an acute funding squeeze — start to appear.
Now funding markets are starting to show signs pressure. Rates on overnight repurchase agreements — loans collateralized by government debt — are rising amid elevated US government issuance and primary dealer holdings of Treasuries near an all-time high.
Meanwhile, balances at the Fed’s overnight reverse repo facility or RRP, considered a measure of excess liquidity in the financial system, reached a three-year low of $239 billion on Sept. 16, yet has ticked higher to $425 billion as of Thursday.
Perli attributes the elevated repo rates to the fact that demand has likely increased relative to supply, given the large increase in Treasury issuance, since investors need financing to acquire them. He also said the ongoing shrinking of the Fed’s balance sheet also adds to higher funding demand because private investors are absorbing more government debt as it rolls off the central bank’s balance sheet.
The other driver of higher repo rates is that frictions have emerged that are interfering with the redistribution of liquidity due to counterparty risk limits, according to Perli. As a result, this has resulted in higher remaining balances at the Fed’s RRP facility even though rates on alternatives have been higher than the offering yield.
Still, liquidity left at the RRP “does not flow into the repo market as smoothly as it did previously, and therefore contributes to higher repo rates,” he said, noting that the market can adapt to these constraints by increasing counterparties though it’s unlikely to unfold quickly. “In the meantime, repo rates may continue to run higher than they would have otherwise, or even increase further.”
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