The Treasury is issuing short-term Treasury bills to reduce interest-rate payments on the government’s expanding debt burden.
Money market funds have responded by taking funds that were parked in the Federal Reserve’s overnight repo facility and using them to buy the newly issued T-bills, which have a longer duration.
This is in anticipation of two possible additional cuts in the federal funds rate and lower returns in the overnight facility.
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The shift in demand for higher-paying short-term securities has pressured the Secured Overnight Financing Rate (SOFR) to as high as 4.51% in the days before the Federal Reserve’s rate reduction on Wednesday and traded above 4.15% in the aftermath of the cut.
The Fed’s rate cut moves the target for the overnight policy rate to a range of 4.00% to 4.25%, with a median federal funds rate of 4.08%. The interest rate on reserve balances is now at 4.15%, with the offering rate on the reverse repo facility at 4%, and the standing repo facility at 4.25%, as reported by Bloomberg.
These changes to the benchmarks will be captured in the Friday release of SOFR.
SOFR, which is ordinarily pegged to the federal funds effective rate, was trading at a premium of 18 basis points compared with the federal funds effective rate at 4.33%. SOFR dropped to 4.39% after the Fed’s announcement on Wednesday.
The Fed’s repo facility smooths out liquidity in the money markets, buying securities to inject cash into the financial markets or selling securities to reduce cash that would otherwise slosh around the financial system.
The abandonment of the facility in favor of holding longer-term T-bills creates a potential liquidity squeeze that could inhibit investment and economic growth.
The abandonment of issuing long-term Treasury notes and bonds would cause price distortions in the bond market.
SOFR and the housing market
SOFR is the short-term benchmark rate underpinning U.S. borrowing and lending. (SOFR replaced the abandoned Libor rates.) SOFR has implications for the housing market, with mortgage rates thought of as being set by SOFR plus a margin for the risk of lending in the residential real estate market.
Through 2023 and during the recent peak in the real estate market, the margin between mortgage rates and SOFR had reached as high as four to five percentage points.
This margin has dropped to fewer than two percentage points this year as the demand for mortgages stabilized in the post-pandemic era and as SOFR gradually increased this year.
The takeaway
The reliance on short-term bills to finance long-term debt has already had consequences and has created conditions where a possible liquidity squeeze can occur.
Still, Federal Reserve Chairman Jerome Powell said that bank reserve balances remain abundant and that the Fed expects to end the runoff of the balance sheet when reserves are at ample levels.
We think that this may occur in the near term as repo rates increase and further reductions diminish.
At the end of Tuesday, there was approximately $18.8 billion in the Fed’s reverse repo facility.
The mortgage market, on the other hand, is being driven by the drop in the demand for housing, implying a top in the housing market. This decline is occurring as SOFR has pushed above the federal funds effective rate, reducing the spread between mortgages and overnight rates.
Given the growing social and policy focus on housing, we are not surprised at emerging talk that the Fed may at one point purchase mortgage-backed securities and other forms of yield curve management.
