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WHY IS THE FED HANDING OUT CASH TO BANKS?

There’s been some funky things happening in recent days deep within the plumbing of the US financial system.

At least one entity (bank or financial institution) was left without enough liquidity for a short period of time.

And “emergency liquidity” (cash) was needed from the Federal Reserve.

This situation is firmly on the Fed’s radar - and is why the Fed is stopping its QT (Quantitative Tightening) regime soon.

But what does it all mean?

There’s been a lot of bad takes flying around.

Is there a banking crisis? (no)

Is there a dollar funding crisis? (not really - yet)

Is the Fed doing QE (Quantitative Easing)? (no)

So, what’s going on?

I’ll tackle this topic in two parts.

Today, we’ll talk about what has happened and what is happening.

Then in another newsletter, we’ll tackle the question of what the Fed will do after it stops QT.

So, let’s take a look…

Money sucked out of the economy and markets

This situation stems from something we’ve been talking about for a long time.

That is the rebuild of the Treasury General Account (TGA) - the US Government's "bank account" at the Federal Reserve.

This process of refilling the TGA started in June after the Government raised the debt ceiling.

The "target level" for this TGA rebuild was $850bn.

Source: TradingView

When cash moves from financial markets into the TGA at the Fed, it can be considered a "liquidity drain" because cash sitting idle in the TGA is essentially "removed from markets".

So, we’ve seen a "liquidity drain" of roughly $700bn in just a few months.

This process also causes bank reserves (a special kind of money used solely within the banking system) to contract.

And this is what has happened - bank reserves have fallen to multi-year lows (shown here as a percentage of GDP).

Source: TradingView

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WHY IS THE FED HANDING OUT CASH TO BANKS? (P2)

Funding issues

This contraction in liquidity within the banking system can cause stress in important dollar funding markets.

We can see this stress through elevated SOFR (Secured Overnight Financing Rate) levels - the rate that banks pay to receive the financing they need.

SOFR spiked relatively high on Friday October 31 (indicating stress in funding markets).

(SOFR is shown here as a “spread” with another static Fed rate to simplify the chart.)

Source: TradingView

I would still characterize the recent SOFR spike as relatively minor.

Nowhere near what we saw in September 2019 - "the Repo Crisis" - which caused a meltdown within the banking system and forced the Federal Reserve to abruptly switch from QT to QE.

Source: TradingView

And on Friday, we also saw some small-scale take-up at the Fed's Standing Repo Facility by banks.

This is essentially an overnight loan from the Fed to banks - or “emergency cash”.

$50bn was tapped on Friday October 31 - the most in years.

This shows that one entity or more than one entity did not have the liquidity it needed to properly function on that particular day.

Source: TradingView

This Fed facility is working exactly as intended - a liquidity backstop.

It's not QE (Quantitative Easing), as some people have claimed.

It's an extremely short-term (24hrs) cash injection only used when a financial institution is in dire need of liquidity.

We’ve been expecting all of this to happen for some time.

I wrote months ago that bank reserves would fall to multi-year lows later in 2025 (this has happened), there would be minor dollar funding stress (this has happened), and the Fed would announce the end of QT before the end of the year (this has happened).

But there are also some not so obvious further issues that have exacerbated the recent situation.

What made things worse on Friday?

There are two other issues that combined and led to a worsening situation on Friday October 31.

1/ If we look back at the TGA balance, you'll see that it has risen past the "target level" of $850bn.

So, we've seen roughly $150bn more "liquidity drain" than expected in recent weeks.

Source: TradingView

I think this is partly down to the ongoing Government shutdown (Government not spending as much money - but still taking in the same amount of money - so money piles up in the TGA).

2/ This is all coinciding with an "end-of-month" (October 31).

It's typical to see banks "window dress" their balance sheets on the last trading day of the month to meet regulatory requirements, usually achieved by moving cash into the Fed's Reverse Repo facility (technically a “liquidity drain” - the opposite of the Standing Repo Facility).

And this is what we saw on Friday October 31 - a normal "end-of-month" spike in Reverse Repo usage, a temporary $50bn "liquidity drain".

Source: TradingView

Wrapping up

An obvious and predictable tightening of dollar liquidity has also coincided with two other less obvious factors.

Which all added together to create some (still relatively minor, but slightly concerning) funding stress on October 31.

This is all now dying down - with Standing Repo usage falling, SOFR levels falling and Reverse Repo usage falling.

The TGA balance should start to fall ("liquidity injection") once the Government shutdown ends.

But if it doesn’t, funding issues will probably crop up again at the end of November (end-of-month) and then again at the end of December (end-of-quarter) - probably getting progressively worse.

It's clear that dollar liquidity is tightening and bank reserves are heading towards levels that could be considered "scarce" (bad).

The Fed needs to stop QT (which it is doing on December 1) - which will largely stop downward pressure on bank reserves.

But the next question - and the question at the centre of rampant speculation - is what will the Fed do next after it stops QT?

This is a question we will cover in a future newsletter - probably next week, if nothing else happens in the meantime.

But for now, that’s it for this edition - catch you in the next one.