Traders are rushing into futures tied to the Fed’s overnight benchmark rate as fears grow that short-term funding could dry up before the quarter ends. On Wednesday in New York, nearly 500,000 fed funds futures contracts for September were traded, breaking a record set in April 2023 when Trump’s tariff news hit markets.
The surge is happening while the effective fed funds rate quietly crept up to 4.09% on Monday. That single basis point move outside of a policy change was enough to rattle the futures market and raise red flags over overnight borrowing stress.
Traders are responding to a tightening repo market, where firms borrow cash overnight in exchange for Treasuries, as month-end and quarter-end always bring more pressure, with shrinking bank reserves and more Treasury bills flooding the market.
Traders expect spike in repo rates before month-end
Scrutiny on the rate has jumped since July. That’s when Treasury started pumping out more bills, while the Fed kept slashing its balance sheet. Bank reserves are now falling. Some traders are warning this combo could lead to serious funding pressure at quarter-end. Dealers slow their repo activity to clean up their books, and that usually pushes up borrowing costs. Everyone’s trying to front-run that pressure.
The bulk of the action in September futures happened during Asia hours, with two blocks of 50,000 contracts traded. That frenzy picked up again once U.S. markets opened, especially as traders eyed the effective rate possibly hitting 4.10% before the month wraps.
For almost 20 years, U.S. funding markets were soaked in cheap cash. Not anymore. Now, rates on very short-term borrowing, used by banks and asset managers, are climbing. That’s because the Treasury is rebuilding its cash pile while the Fed keeps tightening. Meanwhile, use of the Fed’s overnight reverse repo tool, a barometer for excess cash, just fell to its lowest in four years. “We are seeing a level shift in funding,” said Mark Cabana of Bank of America. “Money funds no longer have excess cash to deploy to the RRP.”
As more T-bills get sold, investors move money out of repo and into those bills, which is dragging demand down while pushing rates up.Interest-rate benchmarks tied to overnight repos are now sitting near the Fed’s interest on reserve balances rate, showing the strain.
The spread between repo and the fed funds rate has widened to about 11.5 basis points, the biggest gap since April. That spread was under 10 basis points for most of July and August, before the new wave of T-bills hit.
Fed weighs tools as collateral and reserves drop together
Things may get worse fast. Corporate tax payments and new auctions are about to pull even more money from the system next week. That could upset the balance between cash and collateral — and banks already hold fewer reserves at the Fed. Those balances have fallen to around $3.15 trillion, and Fed Governor Christopher Waller has warned that $2.7 trillion is probably the floor for what counts as “ample.”
Meanwhile, rates tied to overnight financing keep climbing, which creates a headache for the Fed’s quantitative tightening strategy, the balance sheet reduction started in June 2022 and is supposed to finish by year-end. But it’s getting harder to manage with rates rising and reserves shrinking. Roberto Perli, who runs the Fed’s securities portfolio, said the central bank’s short-term interest rate tools will become even more critical in times like this. The more efficiently they work, the less damage markets take.
To avoid another 2019-style repo panic, the Fed now uses the Standing Repo Facility (SRF), letting eligible firms borrow cash by pledging Treasuries or agency debt. That facility charges a rate aligned with the top of the Fed’s target range, now at 4.5%. It saw its biggest usage at the end of June since being made permanent in 2021. But it hasn’t been tested under real stress yet.
JPMorgan’s team said the SRF could contain spikes in repo rates, reducing the need to cut QT short. But others aren’t so sure. September is already looking shaky, and more volatility could force that debate to the front. Some Fed officials, including Waller and Dallas Fed President Lorie Logan, admit funding stress is building. But they’re not pushing for an early end to QT.
