(Bloomberg) — The stability in overnight funding markets this year has strategists suggesting that the Federal Reserve will be able to continue letting its balance sheet run down.
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Since the beginning of the year, demand for leverage, or borrowing, in the funding market has faded as a result of stronger-than-expected economic data and more hawkish Fed officials insisting that the central bank is on track to cut interest rates, just not anytime soon.
This is a sea change from the end of the year when a squeeze in the market for repurchase agreements drove the Secured Overnight Financing Rate to an all-time high. At that time, US Treasuries had cheapened relative to overnight index swaps — a barometer for Fed expectations — as economic data moderated and policymakers appeared more dovish.
That prompted a surge in the so-called basis trade and increased leveraging and short positioning to exploit discrepancies in the Treasury market. No longer, according to Deutsche Bank AG strategists, who are noticing a decline in leveraged funds’ short position in two-, five- and 10-year Treasury futures, which suggests a potential drop in Treasury basis and relative value positions.
If the richness of the bases persists through the end of the current contract cycle, that means smaller positions and less demand for repo financing in coming months.
Such calm in funding markets suggests potentially slower depletion of the Fed’s overnight reverse repo facility or RRP — where eligible counterparties can park cash at a market rate — and a better chance of a later start date to the tapering of the balance-sheet unwind, a process known as quantitative tightening, or QT.
“A decline in hedge funds’ basis and relative value positions, and the associated demand for repo financing could keep RRP usage higher than otherwise, thereby reducing the urgency for the Fed to modify its QT strategies,” Deutsche Bank strategists including Steven Zeng wrote in a note to clients.
Read more: What’s the Basis Trade? Why Does It Worry Regulators?: QuickTake
In the minutes of the latest Fed gathering, policymakers said slowing the pace of the balance-sheet unwind could help smooth the transition to the optimal level of bank reserves or allow the Federal Open Market Committee to continue the runoff for longer. Chair Jerome Powell said the committee will have an in-depth discussion of QT and its assets at gathering next month.
While Bank of America Corp. strategists Katie Craig and Mark Cabana still expect repo rates to push higher, it will require a bit more pressure on Treasuries, and movement of cash out of the front end.
“We continue to expect to see repo rates eventually cheapen but it may require greater UST cheapening, increased collateral issuance, and cash extending out of the front-end,” they wrote in a note to clients.
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