The Fed may need to act as potential trouble brews in a key corner of the financial market

Signs of potential trouble are popping up again in the form of tighter conditions in short-term funding markets, which act as the indoor plumbing of the financial system — and they may require the Federal Reserve to take action relatively soon.

Two measures of funding-market liquidity, known as the Secured Overnight Financing Rate and the Tri-Party General Collateral Rate, have both crept back above 4% during the past week, though remain off their late-October peaks. Both rates are derived from the U.S. overnight repo market, which acts a critical source of short-term funding for a wide range of financial institutions. The Fed monitors pressures in the overnight repo market because of the potential for this to cause wider volatility.

Most Read from MarketWatch

• The Fed may need to act as potential trouble brews in a key corner of the financial market

• Fiserv execs bet $1.5 million on a turnaround, and the stock pops

“This, to us, looks like a repeat of the dynamics seen at October month-end,” said Sam Zief, global macro strategist and head of global FX strategy at J.P. Morgan Private Bank. In other words, these developments are “a sign of tighter funding conditions than investors have become accustomed to in recent years, but not a sign of widespread stress.”

Like the days that followed the end of October, “funding conditions are slowly normalizing this week,” Zief wrote in an email to MarketWatch on Tuesday. The bottom line is “liquidity conditions are tighter than they’ve been in recent years, so small shifts in supply and demand can create more visible volatility in money-market rates. That’s not unusual, but it feels more dramatic because we’ve gotten used to extremely stable rates in a world of abundant liquidity.”

Zief added: “We wouldn’t be surprised to see similar activity at future month-ends unless the Fed starts adding liquidity through open-market operations — something they’ll likely do, but probably not until early next year.”

BNY strategist John Velis said “liquidity is getting tight.” Like Zief at J.P. Morgan Private Bank, Velis said he expects the Fed to intervene in funding markets in early 2026 by using open-market operations.

Strategists at TD Securities and Deutsche Bank have both hinted at the possibility that the Fed might need to act even sooner.

Generally speaking, the U.S. central bank’s goal is to keep bank reserves ample or sufficient enough to control short-term interest rates, to provide a cushion against shocks, and to reduce financial institutions’ reliance on the overnight repo market.

Funding markets, which are designed to ensure a smooth and continuous flow of capital, experienced periodic strains in September, as well as at the end of October and November. Tighter conditions in these markets serve as a warning of reduced liquidity and the potential for broader market disruptions.

Concerns now are that liquidity strains may keep coming back despite the end of the Fed’s balance-sheet reduction efforts, which should theoretically be injecting more liquidity into markets.

The pressure now being seen in funding markets, which coincided with the end of November, suggests that reserves are no longer abundant and “may even be scratching the surface of ‘ample,’” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities in New York. TD sees a rising risk that, in January or potentially even sooner, the Fed will need to announce reserve management purchases, which involve central-bank purchases of Treasury bills as a way to inject more liquidity into the financial system.

Meanwhile, strategists at Deutsche Bank said policymakers could reduce funding pressures by making adjustments to the Interest on Reserve Balances rate, or IORB, which is used by the Fed to keep the fed-funds rate inside its target range. They said they expect this to happen in the first quarter of next year, but noted that others in the market believe it could occur as soon as next week.

On Tuesday, 1-month BX:TMUBMUSD01M and 2-month T-bill rates dropped by between 7 basis points and 10 basis points, respectively, to 3.84% and 3.75%, on slightly higher expectations for Fed interest-rate cuts in December and January. Meanwhile, all three major U.S. stock indexes DJIA SPX COMP closed with moderate gains.

“Repo rates have eased modestly so far and that is expected to continue in the next couple of weeks,” BMO Capital Markets strategist Vail Hartman told MarketWatch. “Nonetheless, there are reasons to be cautious of another flare-up in repo as year-end approaches.”

Most Read from MarketWatch

• Why Snowflake’s earnings beat isn’t enough to lift its stock