Funding Market Strains Spur Wall Street Calls for More Action From Fed

Funding Market Strains Spur Wall Street Calls for More Action From Fed

Strains are re-emerging in crucial short-term funding markets, which serve as the plumbing of the U.S. financial system. Despite a recent calming of pressures, major Wall Street firms are increasingly calling for the Federal Reserve to take further action to ensure market stability. These calls come as the Fed continues to reduce its balance sheet and the U.S. Treasury issues large amounts of debt.

Context & What Changed

The U.S. short-term funding markets, particularly the repurchase agreement (repo) market, are foundational to the global financial system. They allow financial institutions to borrow and lend cash overnight using U.S. Treasury securities as collateral, facilitating the smooth functioning of credit and liquidity across the economy. The stability of this market is paramount; its dysfunction can have rapid and severe systemic consequences, as demonstrated by the September 2019 repo rate spike and the ‘dash for cash’ in March 2020 (source: Bank for International Settlements). The current environment is shaped by two major forces. First, the Federal Reserve is engaged in quantitative tightening (QT), systematically reducing its balance sheet by allowing assets to mature without reinvestment at a pace of up to $95 billion per month (source: federalreserve.gov). This process removes bank reserves, a key form of liquidity, from the financial system. Second, the U.S. Treasury is engaged in massive debt issuance to finance a persistent federal budget deficit, projected to exceed $1.5 trillion annually for the next decade (source: cbo.gov). This floods the market with new Treasury securities that must be absorbed by investors and dealers.

What has changed is the emergence of visible strains and growing anxiety among primary dealers and other major market participants. While acute turmoil has not yet materialized, indicators of stress, such as increased volatility in benchmark rates like the Secured Overnight Financing Rate (SOFR) and rising demand for the Fed's liquidity backstops, have become more frequent. This has prompted explicit calls from Wall Street for the Fed to adjust its operational framework to prevent a repeat of past disruptions (source: finance.yahoo.com). The core concern is that the level of bank reserves is approaching a point of scarcity, where minor shocks could trigger disproportionate market reactions.

Stakeholders

The Federal Reserve (The Fed): As the central bank, it is responsible for maintaining financial stability and implementing monetary policy. Its primary challenge is to reduce its balance sheet to control inflation without inadvertently causing a liquidity crisis.

U.S. Department of the Treasury: As the nation's largest borrower, its debt issuance strategy and cash management practices directly influence the supply of collateral and the demand for liquidity in funding markets.

Primary Dealers & Large Banks: These institutions are at the center of funding markets, making markets in Treasuries and providing repo financing. They are directly exposed to funding stress, and their capacity to intermediate is constrained by post-2008 regulations like the Supplementary Leverage Ratio (SLR).

Money Market Funds (MMFs): These funds are major suppliers of cash to the repo market, primarily through the Fed's Overnight Reverse Repo Facility (ON RRP). A shift in their investment strategy away from the ON RRP and into other assets like Treasury bills is a key dynamic in draining liquidity from the facility.

Hedge Funds & Asset Managers: These entities rely heavily on the repo market to finance their holdings and employ leverage. A disruption would force them into rapid deleveraging and asset sales, amplifying market volatility.

Global Central Banks & Institutional Investors: As major holders of U.S. Treasuries, they depend on the market's liquidity and stability. A crisis would undermine the status of U.S. debt as the world's primary risk-free asset.

Public Finance & Infrastructure Issuers: State and municipal governments, as well as infrastructure project sponsors, rely on stable credit markets. A seizure in U.S. funding markets would increase their borrowing costs and could impede access to capital for critical public works.

Evidence & Data

Evidence of underlying strain is multifaceted. While the article notes that pressures have calmed “lately,” it emphasizes that the “risks of turmoil aren’t gone” (source: marketwatch.com). Key data points illustrating the evolving landscape include:
1. Fed's Balance Sheet Reduction: The Fed’s balance sheet has declined from a peak of nearly $9.0 trillion in early 2022 to approximately $7.3 trillion as of late 2025 (source: federalreserve.gov). This steady withdrawal of liquidity is the primary driver of the tightening financial conditions.
2. Overnight Reverse Repo (ON RRP) Facility Usage: Usage of the ON RRP, which acts as a floor for short-term rates by absorbing excess cash, has been steadily declining. After peaking above $2.5 trillion, balances have fallen significantly, indicating that excess liquidity is being absorbed by increased Treasury bill issuance. While this is an intended effect of QT, a rapid drain to near-zero levels is seen by many as a precursor to potential reserve scarcity.
3. Secured Overnight Financing Rate (SOFR) Volatility: SOFR, the key benchmark for the repo market, has shown increased intra-month volatility, particularly around Treasury settlement dates and corporate tax deadlines. In the September 2019 incident, SOFR spiked from 2.43% to 5.25% in a single day, demonstrating how quickly conditions can deteriorate (source: newyorkfed.org).
4. Bank Reserves: Total reserves held by depository institutions at the Fed have fallen in line with the balance sheet reduction. The critical, yet unobservable, variable is the “Lowest Comfortable Level of Reserves” (LCLOR), below which banks become reluctant to lend, hoarding liquidity for their own needs. Estimates for this level vary, creating significant uncertainty for policymakers.

Scenarios (3) with probabilities

Scenario 1: Proactive Technical Adjustment (Probability: 60%): The Fed, acknowledging the market signals and calls from Wall Street, announces a plan to slow the pace of QT well in advance of reserves reaching a critical level. This is framed as a technical adjustment to its operational framework, not a change in its overall monetary policy stance. The action successfully calms market jitters, funding markets stabilize, and a disruptive event is averted. This scenario allows the Fed to maintain credibility while demonstrating responsiveness to financial stability risks.

Scenario 2: Reactive Crisis Management (Probability: 30%): The Fed maintains its current QT path, underestimating the proximity to reserve scarcity. A confluence of events—such as a very large Treasury auction, an unexpected surge in tax payments, or a minor geopolitical shock—triggers a sharp and sustained spike in repo rates. The Fed is forced to intervene reactively by halting QT and injecting liquidity via large-scale repo operations or asset purchases. While stability is restored, the event causes significant short-term market volatility, damages investor confidence, and raises questions about the Fed's ability to manage its balance sheet.

Scenario 3: Systemic Funding Shock (Probability: 10%): The Fed's policy miscalculation is severe, and the market's internal amplification mechanisms (e.g., forced deleveraging by hedge funds, dealer balance sheet constraints) overwhelm the Fed's initial response. The funding market seizure spreads to other credit markets, forcing widespread asset fire sales and threatening the solvency of some institutions. This would represent a major financial crisis, requiring an overwhelming policy response and likely causing a significant economic recession.

Timelines

Immediate (0-3 Months): Focus will be on key stress points, particularly the year-end 'turn' when banks reduce activity for reporting purposes, and large Treasury auction settlement dates. The commentary and minutes from the next two Federal Open Market Committee (FOMC) meetings will be scrutinized for any change in tone or guidance regarding the balance sheet.

Medium-Term (3-12 Months): This is the most critical window. The cumulative effects of QT will continue to drain reserves, bringing the system closer to the LCLOR. It is within this timeframe that the Fed is most likely to either make a proactive adjustment (Scenario 1) or be forced into a reactive intervention (Scenario 2).

Long-Term (1-3 Years): Regardless of the short-term outcome, the underlying structural issues will require attention. This includes addressing the sheer size of the Treasury market relative to the capacity of primary dealers to intermediate it. Policy discussions will likely focus on regulatory reforms, such as permanently adjusting the SLR, and expanding central clearing in the Treasury market.

Quantified Ranges

Bank Reserves: The key threshold is the LCLOR. While unobservable, New York Fed surveys of primary dealers and market participants suggest a median estimate of around $2.5 trillion to $3.0 trillion. Current reserve levels are approaching the upper end of this range.

Fed's Standing Repo Facility (SRF): The SRF allows eligible counterparties to borrow cash from the Fed against Treasury collateral at a set rate. Its current capacity is $500 billion (source: newyorkfed.org). In a stress event, demand could easily exceed this, and the rate may be too high to prevent market-wide spikes before institutions turn to it.

Potential Rate Spikes: Based on the 2019 precedent, a funding squeeze could see overnight rates spike by 200-300 basis points or more within hours, creating massive uncertainty and triggering margin calls.

Risks & Mitigations

Risk 1: Policy Miscalculation: The Fed waits too long to slow QT, misinterpreting market signals and triggering a liquidity crisis.

Mitigation: The Fed should enhance its framework for monitoring money market conditions, incorporating a wider range of real-time indicators. It should also provide clearer forward guidance on the factors that will guide its decision to slow and then stop QT.

Risk 2: Regulatory Constraints: The Supplementary Leverage Ratio (SLR) treats all assets, including ultra-safe bank reserves and Treasuries, equally. This disincentivizes banks from holding these assets and intermediating in the repo market, especially when their balance sheets are bloated.

Mitigation: Regulators could permanently exclude reserves and Treasuries from the SLR calculation, a move that would significantly increase dealer capacity and enhance market resilience. This has been debated but not yet implemented.

Risk 3: Stigma and Access: The Fed's liquidity facilities, like the SRF and the Discount Window, may be ineffective if banks are reluctant to use them due to a perceived stigma of being seen as needing emergency help.

Mitigation: The Fed should continue efforts to normalize the use of its facilities, framing them as routine liquidity management tools. Expanding access to a broader range of counterparties could also help reduce stigma and improve effectiveness.

Sector/Region Impacts

Financial Sector: A funding crisis would directly impact the profitability and stability of banks, broker-dealers, and MMFs. It would trigger a flight to quality, potentially causing severe dislocations in riskier asset markets.

Public Finance: U.S. federal, state, and municipal borrowing costs would rise. The reliability of Treasury auctions could be called into question, a severe blow to the bedrock of public finance. Infrastructure projects relying on bond issuance would face higher financing costs and potential delays.

Large-Cap Industry: Corporations that rely on the commercial paper market for short-term operational funding would face a liquidity squeeze, potentially impacting their ability to fund payroll and inventory. This risk is particularly acute for non-financial companies with lower credit ratings.

Global Impact: As U.S. Treasuries are the primary global reserve asset, a crisis of liquidity would have immediate international repercussions. It would strengthen the U.S. dollar disruptively, stress foreign financial systems holding large Treasury reserves, and tighten global financial conditions.

Recommendations & Outlook

For Public Sector Leaders (Fed, Treasury, Regulators):
1. Pre-emptive QT Taper: The Fed should develop and communicate a clear plan for slowing the pace of QT, likely beginning in the first half of 2026, to ensure a smooth transition as reserves approach scarcity.
2. Structural Regulatory Reform: Banking regulators should finalize a decision on permanently adjusting the SLR to ease constraints on Treasury market intermediation. This is a critical long-term fix.
3. Enhance Liquidity Facilities: Review the parameters of the SRF, considering a lower rate, broader access, and a larger capacity to ensure it can function as a robust backstop, not a lender of last resort.

For Private Sector Leaders (CFOs, Boards, Financial Institutions):
1. Stress-Test Liquidity: Corporations and financial firms must rigorously stress-test their liquidity profiles against a scenario of a severe, short-term funding market seizure. Over-reliance on overnight, uncommitted funding is a key vulnerability.
2. Diversify Funding Sources: Establish and maintain committed credit lines with a diverse set of banking partners. For large corporations, exploring longer-term debt issuance to term-out short-term funding can reduce rollover risk.
3. Monitor Market Indicators: Closely track key indicators like the SOFR-IORB spread, ON RRP balances, and SRF usage as early warnings of building market stress.

Outlook: (Scenario-based assumption) The most probable outcome is that the Federal Reserve will act on the market's warnings and engineer a proactive adjustment to its balance sheet reduction, successfully avoiding a major crisis (Scenario 1). The public nature of these calls from Wall Street increases the pressure on the Fed to act pre-emptively. However, (scenario-based assumption) the risk of a policy error leading to a sharp but contained market disruption remains elevated (Scenario 2). The fundamental challenge of financing large and persistent U.S. government deficits in a new era of higher interest rates and constrained dealer capacity will be a defining feature of the financial landscape for the foreseeable future, requiring constant vigilance from both public and private sector actors.