AS YEAR-END volatility in overnight funding markets eases, Wall Street is refocusing on how much longer the US Federal Reserve can continue unwinding its balance sheet without causing even worse disruptions.

Traders are back to scrutinising funds in the Fed’s so-called overnight reverse repurchase agreement facility – or RRP – where eligible counterparties can park excess cash. Those users have been pulling money from the facility to capitalise on higher yields elsewhere, but as that facility drains towards zero, volatility in the repo market is expected to heat up anew.

Gyrations in benchmarks such as the Secured Overnight Financing Rate (SOFR), which spiked to a record last week, are set to become more common and severe. In the short term, rates on overnight repurchase agreements – loans collateralized by government debt – are set to normalise this week, once Treasury auctions settle and term funding positions for year-end mature. And SOFR, which is connected to repo transactions, fixed at 5.38 per cent as at Dec 29 down from an all-time high of 5.4 per cent, according to New York Fed data published on Tuesday (Jan 2).

But recent fluctuations in these rates could be just a taste of things to come.

“If the Fed continues to shrink its balance sheet until the RRP facility is emptied out completely, we think SOFR’s day-to-day pattern is likely to resemble the pre-2020 experience rather than the more stable behaviour of recent quarters,” Wrightson ICAP economist Lou Crandall wrote in a note to clients.

Some 78 counterparties parked US$704.9 billion at the RRP on Tuesday, a decline of US$313.6 billion from the prior session – and the third-largest start-of-year outflow since the facility was introduced in 2013.

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Until the last week of the year, balances at the Fed’s facility had plummeted by nearly US$1.4 trillion to levels last seen in 2021. That’s been driven by the Treasury’s deluge of bill issuance and the fact that the monetary authority had finished raising interest rates.

Wall Street strategists have estimated balances at the RRP facility will be completely depleted by the end of the second quarter, at which point the central bank will be compelled to halt quantitative tightening (QT) – especially if it turns out that bank reserves are actually more scarce than policymakers expect.

That’s why Crandall has said the Fed will have to stop its balance sheet run-off before the reverse repo facility is entirely drained. In that scenario, any surplus cash sitting in the facility can be redeployed into the repo market in the event there’s a spike in funding markets.

“As noted in the past, we think there is a strong argument for stopping QT this spring or summer while the everyday level of RRP usage remains structurally positive,” Crandall wrote. BLOOMBERG