US "Dollar Shortage" Rages On: Is the Market Forcing the Fed to Act?

Although the US government just ended its shutdown drama this week, signs of liquidity strain continue to intensify in the $12 trillion money market, which provides crucial daily funding support for Wall Street. This is prompting growing calls from market participants for the Federal Reserve to take further action quickly to alleviate the pressure...

Institutions such as Bank of America, SMBC Nikko Securities, and Barclays have warned that the Fed may need to take additional measures, such as increasing short-term market loans or directly purchasing securities, to inject funds into the banking system and ease the tension that is causing overnight rates to climb persistently.

As previously reported by Cailianshe last week, a series of short-term rates have remained elevated in recent weeks. The Secured Overnight Financing Rate (SOFR) even experienced its largest single-day swing outside of a rate-hiking cycle since the peak of the pandemic in March 2020.

Although the situation eased somewhat thereafter, recent developments suggest it might be "making a comeback." As shown in the chart below, the spread between SOFR and the Fed's Interest on Reserve Balances (IORB) has now widened again to 8 basis points.

The root cause of the liquidity crunch lies in the increased issuance of Treasury bills by the US Treasury, which is drawing funds out of the short-term market and reducing the amount of money within the banking system. Even though the Fed recently announced it would stop reducing its Treasury holdings starting December 1st, the funding tightness has not eased. Some viewpoints worry that even the end of the government impasse might not completely resolve the issue.

The market's concern is that insufficient liquidity could exacerbate market volatility, which would weaken the Fed's ability to control interest rate policy. In extreme cases, it might even force position liquidations, subsequently affecting the US Treasury market—the benchmark for global borrowing costs—especially while the economic outlook remains uncertain.