Welcome to this liquidity watch analysis, where we will address the current stress in USD funding markets and the potential impact on the Fed’s reaction function.

Our best guess is that the current situation will serve as a reason for the Fed to alter the liquidity path significantly in the coming months. Here is a list of the key details you need to pay attention to.

We will answer the following three questions:
1) What’s going on in SOFR rates and is it linked to liquidity stress?
2) What are the lessons learned from the September 2019 liquidity stress?
3) How will the Fed address this in the coming weeks and months? 

What’s Going on in SOFR Rates and Is It Linked to Liquidity Stress?

The recent surge in SOFR-EFFR spreads to over 20 basis points on Monday highlights growing concerns about liquidity stress, particularly during tight quarter-end periods. This widening spread, reminiscent of liquidity issues seen in 2019, though on a smaller scale, suggests one of the first signs of stress as SOFR spikes relative to the Effective Federal Funds Rate (EFFR).

The SOFR-EFFR spread serves as a key indicator of short-term liquidity conditions as the SOFR rate is a gauge of the funding access in repo markets.
A widening spread suggests that there are strains in the availability of overnight cash and that borrowing costs are rising in repo markets. During the September 2019 liquidity crunch, a sharp rise in this spread was triggered by a confluence of factors such as corporate tax payments and Treasury settlements, which left markets short of reserves. 

This forced the Federal Reserve to step in with repo operations to stabilize funding markets. Today’s smaller-scale spike in SOFR relative to EFFR is raising similar alarms about funding pressures, albeit without the same intensity as in 2019.

As we look forward, liquidity has remained tight, especially over the quarter-end turn. Despite expectations, the Overnight Reverse Repo Facility (ON RRP) did not experience its usual drop-off, signaling that liquidity might stay tight during the initial weeks of October. 

Historically, when liquidity falls below a certain threshold—around $6 trillion in the system—SOFR-EFFR spreads tend to react, as we’ve seen now with liquidity dipping a few hundred billion below this critical level. 

We are nearing levels where liquidity pain becomes acute, underscoring the importance of monitoring these developments closely.

Chart 1a: Stress in SOFR is back