The Year-End Money Market Storm

a calm year is set for a volatile conclusion

— programming note: it looks like the Fed and I are on the same page. while I was proofreading and publishing this piece, officials announced they would offer early repo operations at the SRF to contain money market pressures. let’s see if it helps…

The buzz around another explosive year-end, the period infamous for banks pulling back from key dollar markets, has once again emerged. Demand for funding has soared this year, pushing dealer balance sheets to their limits. The Fed’s QT¹ continues to fuel hedge fund demand for basis trades², while euphoria has prompted increasing amounts of levered stock market exposure. Rates to finance such trades have risen so broadly that SOFR — the benchmark funding cost — now trades consistently above an undead Fed Funds (FF) rate. Dealers have even been forced to venture into the darkest depths of funding markets to tap riskier yet cheaper dollars, with trading volumes in the most neglected markets — such as asset-backed commercial paper (ABCP) — staging a mini-comeback. The scene is now set for another year-end rate upheaval.

The media spotlight, meanwhile, has shone on another obscure market putting pressure on dealers: equity repo. For the past year, market makers have financed numerous baskets of large-cap stocks to meet the insatiable demand for longs. An intense craving for stock market exposure and a subsequent rise in price has boosted volumes of equity repos on the BNY’s (Bank of New York’s) triparty platform. Dealers fund some client positions by purchasing stocks and pledging them for cash in repos³, paying an overnight rate until they no longer need funding. While dealers have met the need for longs from hedge funds and other investors, a plunge in short-selling activity has hindered the securities lending market, where dealers usually earn a spread⁴ for loaning equities from their inventories to short sellers. Instead, massive demand for not just longs but leveraged longs has forced market makers to charge a colossal fee, sometimes 100bps (1.00%) or more above SOFR, to warehouse⁵ equities on their already crowded balance sheets.

Simultaneously, a mammoth increase in issuance and an undesirable yield curve have reduced demand for U.S. sovereign debt. Unlike equities, the Fed’s primary dealers serve as the private sovereign debt buyers of last resort and must absorb the largest amount of unwelcome inventory on record. In the secured standard, providing room on your balance sheet is already costly. But now, the supply-demand imbalance in multiple markets has caused the scarcity of funding to reach precarious levels, just as we approach the most restrictive period on the financial calendar. A stormy year-end is looming.