Dear Readers,
Today’s free video and full transcript below take a closer look at the growing signs of tightening liquidity. Reserve balances have fallen again, and with over $100 billion in Treasury settlements this week, funding pressures are likely to intensify.
The SOFR rate remains pinned near the top of the Fed’s target range, reflecting tighter overnight conditions and increased volatility across funding spreads. While some expect the Fed to end QT soon, the data suggest this is more a normalization of liquidity than a crisis — and its effects are beginning to show in risk assets.
As always, my goal isn’t to predict short-term moves but to help you understand how liquidity, volatility, and positioning interact beneath the surface. If you’ve been considering becoming a paid member, now’s a great time to join — I’ll be updating this framework and tracking these liquidity shifts in real time for subscribers.
Take care,
Mike
Fully Edited Transcript by ChatGPT
Reserve balances at the Federal Reserve fell again this past week to $2.93 trillion, signaling continued tightening in market liquidity. This is particularly important as we approach a series of large Treasury settlement dates. On October 28, there will be $26 billion in Treasury settlements, followed by $25 billion on October 30 and $58 billion on October 31. In total, approximately $109 billion will settle this week, a figure that could significantly affect overnight funding rates.
Currently, the Secured Overnight Financing Rate (SOFR), a key gauge of overnight funding costs, stands near 4.25%, the upper bound of the Fed’s target range between 4.00% and 4.25%. The Federal Reserve is expected to cut rates this week, which will likely lower SOFR accordingly. However, SOFR’s current positioning indicates that liquidity in the overnight funding market remains tight, with growing volatility and widening spreads relative to other benchmark rates such as the Interest on Reserve Balances (IORB), the Effective Federal Funds Rate (EFFR), and the Reverse Repo (RRP) rate.
These widening spreads and increasing volatility are clear signs of thinning liquidity. The Effective Federal Funds Rate has also been trending higher, reinforcing this view. Based on Friday’s trading activity in the Depository Trust Company (DTC) repo market, SOFR is expected to rise again when data for Friday is released on Monday. As large settlement dates approach, usage of the Fed’s Standing Repo Facility (SRF) is also expected to increase.
Historically, SRF usage tends to spike on major settlement days. For instance, we saw heightened activity at the end of September, as well as on October 15, 16, 21, and 23. Conversely, on days without settlement activity, SRF usage was minimal. This pattern suggests we will likely see increased repo facility use on October 28, 30, and 31, potentially accompanied by higher funding rates.
This occurs as the Federal Reserve prepares for its policy meeting this week, where speculation has emerged that it might consider halting quantitative tightening (QT). However, current market data doesn’t indicate any immediate crisis in funding markets. While liquidity has tightened, the levels of SRF activity remain moderate and historically comparable to earlier decades when such operations were even more frequent.
In reality, the Fed’s balance sheet appears to be normalizing after years of extraordinary liquidity. The Reverse Repo Facility has fallen to about $2.4 billion from a peak of nearly $2.6 trillion in December 2022. Much of this liquidity needed to exit the system, especially given elevated asset prices. Previously, the effects of QT were muted because as the reverse repo facility drained, it effectively offset balance sheet reductions, keeping reserve balances relatively stable. Now that the reverse repo facility has largely normalized, QT’s full impact is beginning to show.
As liquidity tightens, risk assets are increasingly vulnerable. Although equities haven’t broadly declined yet, Bitcoin has shown clear sensitivity to these shifts. Bitcoin peaked around August 13, coinciding with a spike in the reverse repo facility to $30 billion, and has since trended lower as liquidity drained. Similarly, minor recoveries in Bitcoin prices have coincided with slight upticks in reserve balances, reinforcing the relationship between liquidity and risk assets.
Historically, Bitcoin has been strongly correlated with the Nasdaq 100. While the Nasdaq has held up relatively well recently, early signs of divergence appeared in mid-October, suggesting that liquidity effects could eventually extend to equities. Other liquidity-sensitive sectors, such as regional banks (KRE ETF), private equity firms, and housing-related equities, have already shown weakness. Even large-cap names like Meta have struggled ahead of earnings.
Overall, liquidity dynamics remain a key factor to monitor this week. Although the Fed is unlikely to halt QT at this meeting, continued tightening suggests a gradual normalization of financial conditions — a necessary step for markets to function independently of excess liquidity. Investors should closely watch liquidity gauges, particularly SOFR movements, SRF usage, and reserve balance trends, as indicators of potential stress or normalization in the system.
Defined Terms and Jargon by ChatGPT
Reserve Balances – Deposits that commercial banks hold at the Federal Reserve, representing a key source of system-wide liquidity.
Treasury Settlements – The completion of U.S. Treasury security transactions, where payments are made and securities are delivered.
SOFR (Secured Overnight Financing Rate) – A benchmark interest rate for overnight borrowing collateralized by U.S. Treasury securities.
Interest on Reserve Balances (IORB) – The interest rate the Fed pays on reserves held by depository institutions.
Effective Federal Funds Rate (EFFR) – The weighted average rate at which banks lend reserves to one another overnight.
Reverse Repo Facility (RRP) – A Federal Reserve program allowing institutions to park cash overnight in exchange for Treasuries, influencing short-term interest rates.
Standing Repo Facility (SRF) – A tool allowing eligible institutions to borrow cash overnight from the Fed by pledging Treasuries as collateral, supporting short-term liquidity.
Quantitative Tightening (QT) – The process by which the Federal Reserve reduces its balance sheet, typically by allowing securities to mature without reinvestment, thereby draining liquidity.
TGA (Treasury General Account) – The U.S. Treasury’s operating account at the Federal Reserve, used to manage federal cash flow.
KRE ETF – An exchange-traded fund that tracks regional banking stocks, often used as a liquidity and credit-risk indicator.
Disclaimer
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