Source: Jin10 Data
Author: Xiao Yanyan

In recent days, some very disturbing events have occurred in the market: the repurchase rate corridor of the Federal Reserve - the pillar of the entire American financial system - collapsed, with the General Collateral rate being nearly 40 basis points higher than the reverse repurchase tool rate, which is the upper limit of various overnight rates of the Federal Reserve.

The good news is that a few days later, the General Collateral rate has fallen below the reverse repurchase rate. The bad news is that the events of September 30th indicate how close investors are to another reverse repurchase market collapse and systemic liquidity crisis.

The situation is so severe that it has prompted one of the most renowned reverse repurchase experts to break the silence!

One of the most well-known interest rate strategists at Bank of America, Mark Cabana, may be best known for correctly predicting the Fed's intention to roll out 'wartime measures' to take over the market back in March 2020. Just a few hours before the Fed announced the start of monetizing bond ETFs, Cabana foresaw this scene. Shortly thereafter, in the scariest days of the COVID crisis, the Fed, unsure who to turn to for advice, tried to trace how and where they could reach this former Fed trader, analyst, and current BofA strategist.

As we all know, everything changed in 2020. As part of systemic bailout efforts, the Fed not only purchased bond ETFs but also initiated the largest historically liquidity injection, injecting trillions of dollars of currency equivalents into the financial system - including record daily quantitative easing injections, injecting reserves into banks, and implementing historic reverse repurchase operations while maintaining zero interest rates - all to thaw the financial system.

The scale of the liquidity glut is so huge that its operation has almost no obstacles. But good things will end one day, and on September 30th, the market once again discovered how close the American financial system is to another liquidity crisis.

What exactly happened?

As Kabana wrote in his latest must-read note, the current funding situation is remarkably similar to that of 2019. Since the first half of September, approximately $260 billion in reserves has flowed out of the US banking system due to three different factors.

As reserves leave the financial system, repo rates suddenly soared to the highest level since the financial system was paralyzed due to the COVID-19 pandemic. To some extent, this is natural. At quarter-end, especially at year-end, there usually are some fund tensions as banks aim to streamline funds as much as possible before the financial reporting date. Therefore, SOFR (and other financing cost indicators) usually spike a bit at that time. But this spike is much larger than usual. Kabana estimates that this is the largest single SOFR spike since the market took a hit from the COVID-19 pandemic in early 2020, occurring with record trading volumes.

The sharp drop in reserves is due to the following three factors: 1) an increase in cash balances at the end of the quarter, 2) a decrease in Bank Term Financing Program (BTFP) balances due to recent rate cuts by the Fed, and 3) balance sheet window dressing at the end of the third quarter. Kabana stated that he initially too hastily believed that the rate spike was due to a shortage of short-term collateral and substantial window dressing by banks. In a report released yesterday, he admitted to overlooking some potentially more ominous things: the outflow of reserves from the banking system.

The result is that the reduction in cash hindered end-of-quarter funding growth, leading to a term you may not have heard of but will soon hear more about: LCLoR, the Lowest Comfortable Liquidity Reserve level (if reserves fall below this level, the market freezes, the Fed panics, and terrible things generally happen).

Kabana and other Fed experts like Zoltan Pozsar have long believed that LCLoR is around $3-3.25 trillion.

Similar situations occurred in September 2019, when the Fed did not pay attention to the signs of increasing tension in the money markets. Eventually, it forced the Fed to inject funds into the financial system to prevent a larger disaster. At that time, changes in reserves showed similar changes to the SOFR-IOER (Secured Overnight Financing Rate with US Treasury collateral - Interest on Excess Reserves) and peaked during the Fed's so-called 'Not QE' policy, which lasted several months before the mysterious appearance of COVID-19 triggered the largest liquidity injection in history.

Cabana concluded that at that time, "SOFR (can always be seen as a representation of the degree of monetary tightening) has sensitivity to reserve correlation close to LCLoR. We feel there is a similar situation today."

He said "similar", not completely the same, because this time in addition to the 3 trillion US dollars in reserves (accurately 3.09 trillion US dollars), there is also 300 billion US dollars in liquidity support, namely reverse repo tools. However, under QT and the impact of upcoming US Treasury bond issuances, the depletion of reverse repos is only a matter of time (especially if the Treasury injects bonds into the system again in the next crisis), total reserves will fall below 3 trillion US dollars, which will mark the beginning of the next panic for the Fed.

Editor/rice