From US Financing Rates Edge Higher, John Velis, FX and Macro Strategist for the Americas
In recent days, however, SOFR and GC have offered higher returns with just a one-day duration, taking more money out of RRP as a result. MMFs can earn more in these markets than in RRP, while avoiding longer-dated bills. This is especially true as the longer-dated bills are yielding less than the RRP’s 5.3%, given expectations – mistaken, in our opinion (see here) – of potential Fed rate cuts as early as the FOMC meeting next March.
As we said above, our suspicions are that these secured financing rates are being squeezed higher due to year-end liquidity needs; investors are locking in funding through the year-end now. This means that if this funding wave abates in coming days and weeks, less RRP money will enter the markets as quickly.
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Combined with the discussion in the opening section on the anomaly in short-term rates and the RRP drain, we think there are still legs to the basis trade, even though the broader market is beginning to price in cuts as early as the end of Q1. Does this spell the end of the basis trade? And what would this do to MMF behavior? We think that rates will stay higher than the market currently foresees, and also that supply pressures in the coupon market will keep 10y yields elevated. This should allow the basis trade to endure, with MMFs continuing to place cash in FICC repo, ultimately supporting this equilibrium. This means that RRP should continue to drain.