Back in September, there was an unexpected short-term liquidity crisis in overnight repo markets with lending costs hitting as high as 10%. The Federal Reserve stepped in and set up a temporary lending facility and increased the balance sheet to prevent a recurrence and keep interest rates within its target range.

In his press conference following the FOMC meeting, Chairman Jerome Powell stated they will continue closely monitoring the situation and may make further moves if these initial moves are not sufficient. There's concern that the crisis may flare up once again at year-end when banks are hoarding cash to meet regulatory requirements.

Dissenting Views

While these types of "financial plumbing" activities are complicated and opaque, it doesn't stop market participants from using the confusion to manufacture narratives that suit their biases. Those skeptical of the Federal Reserve see this as a stealth form of quantitative easing (QE). As evidence, they point to the Fed balance sheet. From late-2017 to mid-2019, it shrunk by $600 billion as the Fed let its Treasury and mortgage backed securities (MBS) holdings roll over.

Since then, the balance sheet has started rising again. And some are pointing out the connection between the Fed balance sheet growing and outperformance in risk assets over that period. However so far, there's no evidence of these reserves entering the system via more lending.

Others with more benign views simply see the Fed using its tools to ensure that interest rates stay within its range and financial markets continue operating effectively. They see changes in the balance sheet as a necessary counter to increased volatility in excess reserves following the financial crisis. Another factor adding to volatility in reserves was the Fed removing limits on foreign banks from participating in the repo market.

Just like a portfolio manager must manage risk more aggressively with a volatile stock, banks boosted their own cash reserves to counter the volatility in reserves and then boosted them more when the repo market went haywire. Given that Treasury issuance will increase in the following years due to the soaring deficit, the repo market will continue to be under strain. Treasury demand will ensure heavy demand.

When companies need to make tax payments or meet increased regulatory burdens, they withdraw money from money markets which reduces repo supply. Thus, the combination of increased demand and decreased supply can lead to shortfalls and disruptive spikes in rates.