2025-10-27 21:38:41
The Fed sets interest rates as it sees fit, but it is losing control of its balance sheet policy to the growing fiscal deficit. Fed officials look to repo rates for signs of reserve scarcity, which influences their decision to shrink or expand their balance sheet. But repo rates are determined by supply and demand and not simply the level of reserves. Demand for repo financing continues to grow rapidly from the increasing fiscal deficit, while the supply of repo financing can only keep up with the help of the Fed. Stable repo rates would ultimately require persistent Fed balance sheet expansion and effectively cede control of its balance sheet size to the fiscal authorities. This post reviews the supply and demand factors that have driven repo rates above interest on reserves and suggests that balance sheet expansion will resume shortly after QT.
The demand for repo financing is insatiable because the $2t fiscal deficit is in part financed by leveraged investors. Treasury repo volumes remained steady through most of 2022, but began a steady ascent as the supply of Treasuries to the private sector grew rapidly. Both the Fed’s QT program and continued net issuance increased the supply of Treasury securities to private investors. Some of the investors purchased Treasuries with cash, but others financed their purchase with a repo loan. These leveraged investors often bought cash Treasuries as part of a cash futures basis trade, which has grown over a trillion in size. Demand for repo financing will continue to grow with the growing fiscal deficit, which is expected to be about $2t annually for the foreseeable future.
The available amount of repo financing is enormous, but it is not enough to keep up with the growing demand. The primary repo lenders are the money market funds and commercial banks, who each have different opportunity costs. The largest pool of cash is the $7t money market fund complex, whose opportunity cost is the RRP offering rate. MMFs place cash in the RRP facility when they have nowhere else to invest, so a high RRP balance implies excess cash that could be used to meet repo financing demand. RRP balances have gradually declined to zero as MMFs deployed cash to fund repo loans and purchases of Treasury bills. As RRP balances dwindled, repo rates steadily rose to entice the next marginal lender.
The next marginal lenders are the prime money market funds and Federal Home Loan Banks, whose opportunity cost is the overnight unsecured rate. Prime funds and FHLBs lend in the overnight unsecured market because they can usually earn a little bit more return by taking on unsecured credit risk. The borrowers in the overnight unsecured market largely just park the proceeds at the Fed to earn interest on reserves, so they are not willing to pay up for funding. Repo borrowers can bid away cash from these lenders, who are happy to earn higher returns with lower risk. Volumes in overnight unsecured markets declined by $100b as repo rates steadily moved above overnight unsecured rates.
The final layer of repo lending is the commercial banks, whose opportunity cost is interest on reserves. Commercial banks hold about $3t in reserves, which are deposits at the Fed that earn IOR. A Treasury backed overnight repo loan is equivalent to reserves under a range of regulations, so banks feel comfortable lending in repo when it is trading at a spread to IOR. The amount of cash they have available to lend fluctuates with their business needs, so their lending is less consistent and can lead to greater rate volatility. Note that banks are net lenders in repo rather than borrowers, so higher repo rates do not imply banks lack reserves.
The Fed is expected to stop QT by the end of the year in part due to rising repo rates, but repo rates will continue to increase even after QT. The Fed perceives higher repo rates as a sign that reserves have become scarce and are eager to avoid a repeat of the September 2019 repo spike, which they link to over doing QT. Reserve levels can impact repo rates through the bank lending channel, where lower reserve levels mean banks have less cash to lend into repo. But repo rates are rising in large part due to an increasing demand for repo financing, so just looking at the supply of cash is incomplete. Without a change in fiscal policy, any amount of cash will ultimately be exhausted.
A steady expansion of the Fed’s balance sheet is the most likely way to meet the growing financing demands of the Treasury. The Fed could do this through its standing repo facility, where it lends according to the needs of repo borrowers. The facility has so far seen limited take-up and does not appear to constrain repo rates. They could also buy Treasury bills to add reserves into the banking system, who could then lend them into the repo market. It is also possible that commercial banks could increase their lending in repo by expanding their balance sheet and not just shifting the composition of their assets, but that is not likely under current regulations and spreads. The end of QT is coming soon, and further growth in the Fed’s balance sheet will necessarily follow shortly.
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2025-10-06 17:27:07
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