Short-term funding "volatile" but Fed balance sheet drawdown "on track," UBS says

Investing.com - Short-term funding is likely to remain volatile through at least the end of the year, but not be "disorderly," according to analysts at UBS.

Overnight funding costs in the U.S. were elevated in the first half of September, climbing well above the Fed’s target range to 4.51% on September 15, but have since declined.

A mixture of events at the end of the third quarter, including corporate tax days and coupon settlements, have raised worries of a potential repeat of September 2019. At the time, overnight funding costs in the repurchase -- or repo -- market surged because of large corporate tax payments and other payments on Treasury debt, which weighed on bank reserves and forced the Federal Reserve to inject liquidity into the repo market.

More recently, signs of stress have started to emerge, including an uptick in borrowing cash overnight that is collateralized by Treasuries, although money market conditions are now bolstered by the Fed’s introduction of an emergency liquidity facility -- dubbed the Standing Repo Facility (SRF) -- and bank reserves which are at higher levels than in 2019.

"Intraday swings and wider spreads reflect seasonal and structural pressures than a 2019-style crisis. To corroborate that view, SRF usage suggests markets can still find cash without heavy Fed intervention," the UBS analysts said in a note.

Still, a jump in U.S. Treasury bill issuance this year and an ongoing push by the Fed to shrink its balance sheet -- a process known as "quantitative tightening" -- will likely "keep the focus on reserve levels" heading into the end of 2025, the analysts flagged.

They added that "surprise spikes" in overnight lending rates in the general collateral repo market may intensify scrutiny over whether "ample reserves" are built into the financial system.

One test of the Fed’s liquidity facilities could come in the final days of this month, market observers have said, as lenders and other firms navigate typical month- and quarter-end volatility even as the Fed continues to draw down its balance sheet. But the Fed’s QT drive is still "on track," the UBS analysts said.

The central bank is seen maintaining a reserve floor of $2.5 trillion to $2.7 trillion, they estimated, noting that total bank reserves now stand at a little over $3 trillion.

"[W]hile the system is edging closer to that threshold, we think that reserves will not fall below $2.7 trillion till the second half of 2026," the analysts wrote.