The U.S. Treasury is issuing more short-term T-bills to lower interest payments on government debt.
Key takeaways
SOFR spiked before the Fed’s recent rate cut, then settled near 4.39%.
The use of the Fed’s repo facility dropped as funds moved to longer-duration T-bills.
The Treasury is issuing short-term Treasury bills to reduce interest rate payments on the government’s expanding debt burden.
Money market funds have responded by taking funds that were parked in the Federal Reserve’s overnight repo facility and using them to buy the newly issued T-bills, which have a longer duration.
This is in anticipation of two possible cuts in the federal funds rate, in addition to the most recent reduction, and lower returns in the overnight facility.
The shift in demand for higher-paying short-term securities pressured the secured overnight financing rate (SOFR) as high as 4.51% in the days before the Fed’s rate reduction on Sept. 17, after which it fell to just above 4.15%.
The Fed’s rate cut moved the target for the overnight policy rate to a range of 4% to 4.25%, with a median federal funds rate of 4.08%, as of Sept. 17. The interest rate on reserve balances was at 4.15%, with the offering rate on the reverse repo facility at 4%, and the standing repo facility at 4.25%, as reported by Bloomberg.
Before the Fed’s announcement, SOFR, which is ordinarily pegged to the federal funds effective rate, had been trading 18 basis points higher than the federal funds effective rate of 4.33%. SOFR dropped to 4.39% after the Fed’s rate cut.
The Fed’s repo facility brings liquidity in the money markets, buying securities to inject cash into the markets or selling securities to reduce cash that would otherwise slosh around in the financial system.
The move away from the facility in favor of longer-term T-bills creates a potential liquidity squeeze that could inhibit investment and economic growth.
Discontinuing the issuance of long-term Treasury notes and bonds would cause price distortions in the bond market.
SOFR and the housing market
SOFR is the short-term benchmark rate underpinning U.S. borrowing and lending. (SOFR replaced the abandoned Libor.) SOFR has implications for the residential real estate market, with mortgage rates thought of as being set by SOFR plus a margin for the risk of lending in that market.
Through 2023 and during the recent peak in the real estate market, the margin between mortgage rates and SOFR had reached as high as four to five percentage points.
This margin has dropped to fewer than two percentage points this year as the demand for mortgages stabilized in the postpandemic era and as SOFR gradually increased this year.
The takeaway
The reliance on short-term bills to finance long-term debt has already had consequences, creating the conditions for a possible liquidity squeeze.
Still, Fed Chair Jerome Powell said that bank reserve balances remain abundant and that the Fed expects to end the runoff of the balance sheet when reserves reach ample levels.
We think that this may occur in the near term as repo rates increase and further reductions diminish.
The mortgage market, on the other hand, is being driven by the drop in the demand for housing, implying the housing market may have peaked. This decline is occurring as SOFR has pushed above the federal funds effective rate, reducing the spread between mortgages and overnight rates.
Given the growing social and policy focus on housing, we are not surprised at emerging talk that the Fed may at one point purchase mortgage-backed securities and other forms of yield curve management.
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