The U.S. financial markets face another severe test: Former Federal Reserve trader warns that a repurchase crisis is imminent

The pillar of the U.S. financial system is showing cracks, and another repurchase crisis is looming...

In early October, a highly disturbing event occurred in the market, as the Fed's repurchase rate corridor, which serves as the pillar of the entire U.S. financial system, broke down - with general collateral rates soaring to nearly 40 basis points above the reverse repurchase rate. The reverse repurchase rate is the upper limit of various overnight rates set by the Fed, and this "ceiling" is used by banks to dress up their balance sheets by absorbing as much liquidity as possible, especially at month-end and quarter-end.

Although a few days later the general collateral rates had fallen below the reverse repurchase rate, some analysts pointed out that this event is enough to raise alarm bells, as investors are so close to another reverse repurchase market collapse and systemic liquidity crisis.

Former Fed trader and current Bank of America rate strategist Mark Cabana warned that the U.S. may be facing a new repurchase market crisis.

A Repeat of the 2019 Crisis?

Cabana pointed out that the current financing situation is very similar to the situation before the 2019 repurchase market collapse. At that time, the overnight rates in the U.S. repurchase market soared, leading to severe liquidity risks in the money market.

In March 2020, he boldly predicted that the Fed would introduce "wartime measures" to take over the entire market, and a few hours later, the Fed announced that it would start monetizing bond ETFs.

Since early September, approximately $260 billion has flowed out of the U.S. banking system due to an increase in the Treasury General Account (TGA) balance at quarter-end, the recent Fed rate cuts leading to a decrease in BTFP balances, and balance sheet dressing at the end of the third quarter. Subsequently, as reserves left the system, the repurchase rate suddenly soared to its highest level since the financial system was paralyzed by the COVID-19 pandemic.

Cabana also stated that he may have overlooked the impact of reserve outflows on market pressure. Currently, the sensitivity of reserves to the SOFR rate has increased, implying that the market may be approaching the lowest comfortable reserve level (LCLoR). In theory, when reserves fall below this level, there is a risk of liquidity exhaustion, causing panic at the Fed, which usually leads to a "crisis".

Exhaustion of Reverse Repurchase is only a matter of time

For a long time, Cabana and other Fed experts have believed that the LCLoR is around $3-3.25 trillion.

Cabana mentioned that a similar situation occurred in September 2019, when the changes in reserves showed a similar correlation with SOFR-IORB (the U.S. Treasury-backed overnight dollar rate - deposit reserve rate), peaking under the Fed's "non-quantitative easing" After several months of continuous liquidity injections, the market has received the largest liquidity injection in history.

However, some analysts point out that the "similar situation" in 2019 does not mean it is completely the same. This time, in addition to the $3.09 trillion in reserves, there is also $300 billion in liquidity support, namely reverse repurchase agreements.

Nevertheless, quantitative tightening has not ended yet. The upcoming new round of U.S. Treasury bond issuance will impact the market. Analysts believe that the exhaustion of reverse repurchase agreements is only a matter of time, especially if the Treasury injects government bonds into the system again during the next crisis. The total reserves may fall below $3 trillion, leading to another liquidity crisis in the market