JPMorgan Sees Fed Funds Rate as an Imperfect Liquidity Measure

(Bloomberg) — The small size of the federal funds market makes its key rate an imperfect metric as the Federal Reserve gauges liquidity in the US financial system, according to JPMorgan Chase & Co.

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Just last week, the New York Fed debuted a gauge that showed reserves in the banking system are in balance with demand for them, offering evidence the US central bank can keep removing liquidity from the system via its quantitative tightening program. The tool is calculated using data on fed funds transactions and reserve amounts.

“Taking a step back, we are somewhat surprised that the Fed appears to be placing more weight on the fed funds rate as a gauge of liquidity in the marketplace,” JPMorgan strategists Teresa Ho and Pankaj Vohra wrote in a report published Friday. “While the fed funds rate reflects the price at which banks trade their ‘excess’ reserve balances, the fed funds market is small.”

Market participants have been closely watching liquidity gauges and funding markets for clues on when the Fed’s QT will cease, and whether it will end before liquidity pressure grows worrisome. Dallas Fed President Lorie Logan on Monday said liquidity in the market remains “more than ample.”

Roberto Perli, the System Open Market Account manager, has laid out a slew of metrics watched by officials to determine the point at which bank reserves start to become scarce — and the Fed’s QT likely has to stop.

JPMorgan said the Fed will likely finish QT by the end of 2024 “as any further liquidity drain will increasingly impact reserves.”

To the strategists, the limited set of participants and the small size of the fed funds market makes the rate “surprising” as a focus of the Fed. Daily volumes in the fed funds market is generally in the $50 billion to $100 billion range. By contrast, the market for overnight loans collateralized by Treasury securities — used by the New York Fed to calculate the Secured Overnight Financing Rate — exceeds $2 trillion a day.

Also, Federal Home Loan Banks do most of the lending of reserves in the fed funds market, whereas SOFR transactions sweep in “a wider set of market participants,” including banks and non-banks, according to JPMorgan.

“In other words, SOFR provides a more comprehensive gauge of liquidity in the marketplace in that it reflects the liquidity needs of a range of market participants,” they wrote.

While a spike in SOFR over several days beginning in late September wasn’t necessarily a sign that reserves had become scarce, the strategists said it’s an indication “that redistributing reserves in the financial system to those that need liquidity is becoming more challenging.”