The Money Market Blindspot: Part II

volatile flows could impede the Fed's "alarm system"

— click here for The Money Market Blindspot: Part I

Another debt ceiling battle is set to induce volatility in money markets. Under the command of newly sworn-in Scott Bessent, the U.S. Treasury has started employing “extraordinary measures” to bypass a now-binding debt limit¹. Yet, these gimmicks won’t last forever. Soon, America’s checking account, the TGA², will be drawn down, releasing a flood of liquidity into the banking system. Anticipating a cash surge in the first half of the year, the SOFR-FF (SOFR-Fed Funds) futures curve³ — a measure of expected funding conditions — has thus priced in a looser environment⁴. This easier climate, however, will soon be altered by a giant collection of tax receipts⁵, an unwind of liquidity that could be deepened by a parallel debt limit resolution⁶. With not only the U.S. government’s bank account but the RRP also complicating flows, the Fed’s liquidity “alarm system”, eager to front-run⁷ the next money market upheaval, is about to face its first major hurdle.

since futures are quoted as 100 minus the implied market rate, a positive SOFR-FF futures basis means SOFR is priced to trade below (not above) EFFR and vice versa

At the latest FOMC meeting, monetary leaders again confirmed their desire to maintain the smallest possible balance sheet⁸, superseding their urge to end QT⁹ and thwart another money market seizure. Consequently, only an unforeseen rate spike will compel officials to abandon their objectives. But for now, reserves lost to the U.S. central bank’s “QT shredder” will be more than offset by Sec. Bessent drawing down (i.e. draining) the TGA¹⁰, lowering repo rates — while costs to borrow overnight Fed Funds (o/n FF) continue to flatline. The U.S. central bank’s premier gauge of reserve scarcity, RDE (Reserve Demand Elasticity)¹¹, hovers around zero, implying subtle changes in reserves will fail to drive o/n FF toward the top of the target range and disrupt the Fed’s goals. Without RDE falling sharply negative¹², the Fed will have the conviction to continue its balance sheet “runoff”¹³, an action the U.S. central bank no longer deems tightening but a “normalization”. Volatility in funding markets is subsequently looming.

Unfortunately for officials, upon a debt limit resolution, a TGA drawdown will evolve into a TGA refill¹⁴, where both dollar funding and liquidity tighten. Short-term desks and STIR traders¹⁵ appear to be pricing an end to easing sometime in Q2, as the SOFR-FF futures curve turns from flat and positive to downward and negative¹⁶. A double whammy of tax receipts and a TGA cash reload is about to produce turbulent money market flows, but with volatility comes opportunity.