Wall Street warning: Currency market tension may persist until November, Federal Reserve reverse policy forced by the market.

Wall Street analysts said that the tight situation in the currency market may persist until November, as funding costs remain high, putting pressure on the Fed to take action to supplement liquidity before stopping balance sheet reduction next month. The currency market just ended a volatile month, with the secured overnight financing rate soaring 18 basis points last Friday. This was the largest single-day volatility outside of a Fed rate hike cycle since March 2020. Although SOFR dropped slightly on Monday after related pressures eased at the end of the month, it still remained above the Fed's key policy benchmark rates - including the federal funds rate. Other short-term interest rates in the interbank repurchase market continued to trade above the Feds managed rates. Mark Cabana, head of US interest rate strategy at Bank of America, said, The Fed is running out of time, they seem a bit disorganized. December 1 is the only compromise they could reach. I suspect the market will soon force them to react. Due to increased funding pressures in recent weeks, the Fed announced last week that it would stop reducing its holdings of US Treasury bonds in December, ending a three-year quantitative tightening effort. As currency market liquidity continues to dry up, with a large amount of government debt issuance attracting more funds away from the market since this summer, the Fed is continuing to reduce its balance sheet. Bank of America had previously expected the Fed to end quantitative tightening at the end of October and immediately start purchasing assets to expand its balance sheet. Cabana said the lack of such measures indicated there were "differing views" within the Fed. Fed Chairman Powell said last week that at some point, the Fed would gradually increase reserve sizes to keep pace with the banking system and economic developments, but he did not specify a time. Other Fed officials, including Vice Chairman for Supervision Michael Barr, believe that the central bank should strive to keep its balance sheet as small as possible. A Fed spokesperson declined to comment. US bank strategists believe that the Fed has withdrawn reserves excessively, reducing them to a level that could be considered "adequate" for buffering the minimum level required to counter market distortions. The latest data shows bank reserves have fallen to $2.8 trillion, the lowest level since September 2020. Dallas Fed President Robert Kaplan said on Friday that if repo rates remain high, the Fed will need to purchase assets, and she expressed disappointment in seeing tri-party repo rates surpass the Fed's standing repo facility rate. The SRF allows eligible institutions to borrow cash swapping US Treasuries and agency debt, and the tool has been used frequently in recent weeks, being reactivated on Monday. Kaplan, who has worked in the New York Fed's Markets division for over twenty years, believes that the Fed should aim to have money market rates averaging near or slightly below the interest on reserve balances (IORB). On Friday, SOFR was 32 basis points higher than IORB, the largest spread since 2020, falling to 4.13% on Monday. It remains above IORB (currently 3.9%) and the effective federal funds rate - the latter was lowered by 25 basis points to a range of 3.75%-4% by policymakers on October 29th. Another benchmark related to repurchase operations - the GC repo rate - has also been above 4% since October, constantly higher than the managed rates. Joseph Abbate, US rates strategist at SMBC Nikko Securities America, stated in a report on Tuesday that pressure in the tri-party market may be higher than levels indicated by published rates, advocating for the Fed to take "more proactive" action, including purchasing Treasury securities. Abbate writes, "We suspect the market may be more susceptible to overnight funding rate pressure than in 2019," referring to the turmoil that shook the currency market in September 2019. He pointed out that large hedge funds have increased their long positions in US Treasuries by around $1 trillion compared to six years ago, and the use of repurchase financing has nearly doubled. In 2019, following a spike in repo rates, the Fed injected $500 billion into the market. Wall Street strategists believe the Fed may need to take similar actions this time to alleviate tensions around US Treasury settlements or key payment dates. John Velis, macro strategist at BNY Mellon, said, "If this funding market pressure continues and rates rise above relevant Fed rates, we do not rule out the possibility of temporary open market operations."