Fed faces test on liquidity management on September market challenges

By Michael S. Derby

Sept 12 (Reuters) - The remainder of September could prove to be pivotal for the Federal Reserve's efforts to wind down its massive bond holdings, as well as a key test for the U.S. central bank's liquidity facilities.

On Monday, financial markets will navigate a tax payment and auction settlement date that could weigh on market liquidity and pressure short-term interest rates higher. And regardless of how that goes, September will end with a double whammy by closing out the month and the quarter, which will almost certainly pressure markets and could temporarily push a substantial amount of cash onto the Fed's books.

A Fed monetary policy meeting on September 16-17 will almost certainly bring an interest rate cut, which could also fuel money market volatility.

Depending on the pressure in money markets, this month's events could bear significantly on how much further the Fed has to go to wind down its balance sheet by quantitative tightening, or QT.

September liquidity events loom large for market participants because in that month in 2019, another QT chapter was abruptly brought to a halt due to an unexpected shortfall in liquidity. Managing short-term market liquidity is critical for the Fed because that is how it keeps its short-term interest rate in line with the direction set out by the central bank's Federal Open Market Committee.

There is a considerable amount of uncertainty about how much pressure money markets are about to face and how the Fed will react. But the matter has gained urgency as the cash that eligible firms have been parking at the Fed's reverse repo facility has essentially moved to zero.

The Fed's reverse repo facility is a proxy for excess liquidity. It grew rapidly as the Fed more than doubled its balance sheet to $9 trillion amid bond purchases aimed at stabilizing markets and providing stimulus during the COVID-19 pandemic.

QT, which began in 2022, has shrunk Fed holdings, and reverse repo usage has fallen from its $2.6 trillion peak at the end of 2022 to $17 billion on Friday. With the Fed still allowing up to $5 billion in Treasuries and $35 billion in mortgages to mature and not be replaced each month, QT is now expected to eat into what have been steady bank reserves, which in turn raises the risk liquidity could run short quickly.

Fed officials have said they see room for QT to run and few signs that market liquidity has grown tight. They have also cited the Standing Repo Facility, which allows banks to quickly convert Treasury bonds to cash, as a key shock absorber for any temporary cash management challenges.

The Fed's challenge is that the facility has only had a couple of relatively light usage periods, and it is unclear how it will perform when demand truly spikes, which could happen at the end of the month.

New York Fed officials have also reminded markets that more traditional liquidity tools are also on the table by way of temporary interventions by the central bank to de facto borrow bonds, something that was once the primary way Fed officials managed liquidity.