U.S. Repo Rates Continue to Weaken Due to Multiple Factors

Overview

This Morgan Stanley U.S. interest rate strategy report provides an in-depth analysis of the persistent weakness in U.S. short-term funding markets (particularly the repo market). The report notes that the secured overnight financing rate (SOFR) has reached the lower bound of the Fed Funds rate, averaging 7 basis points below IOBR over the past 20 days, and attributes this to five key factors. The core conclusion is that these structural factors have alleviated funding pressure, supporting the continuation of a long position in the 2-year U.S. Treasury swap spread.

Core views

The extreme weakness in repo rates results from multiple forces. First, a key demand-side factor is the reduction in cash-futures basis trade volumes. This trade, dominated by hedge funds, is a significant source of demand for U.S. Treasury collateral in the repo market, with its scale estimated to have decreased by $15 billion to $13.5 trillion, the lowest level in over a year. This directly reduced demand for repo financing, depressing the equivalent repo rates and ultimately transmitting to SOFR. Second, the behavior of major market participants has shifted. Following the Iran conflict, U.S. banks have slowed their Treasury purchases due to heightened uncertainty around the Fed's interest rate path, with year-over-year growth in Treasury holdings nearing the lowest level in two years. Meanwhile, they have deployed more cash into the front-end market, causing the total amount of Fed funds sold and reverse repo volumes to approach three-year highs, further depressing repo rates. Additionally, temporary excess cash inflows from government-sponsored enterprises like Fannie Mae and Freddie Mac, along with MMF assets reaching a record $82.81 trillion, which have shifted their portfolios toward repo due to increased uncertainty, have exacerbated the supply-demand imbalance in the repo market. Finally, changes in the regulatory environment have played a significant role. The eSLR leverage ratio reform reduced previous constraints on dealers participating in Treasury and repo activities (particularly as intermediaries). The report observes that since the early adoption of the new rules in early 2026, dealers' Treasury positions have approached record levels, and proxy indicators measuring intermediary costs, such as SOFR spreads and GCF-TGCR spreads, have been trending downward. The proposed new GSIB rules may further increase Treasury repo intermediary activity.

Analysis framework

The report employs a classic supply-demand framework to dissect price behavior in the short-term funding market. The core thread is confirming the 'abnormal weakness' of repo rates by tracking changes in the spread between SOFR relative to IOBR and EFFR. The analysis then focuses on identifying the root causes of this supply-demand imbalance, rather than simply attributing it to the Fed's QT or reserve management operations. In terms of specific methodology, the report cross-validates across multiple market participant dimensions: estimating hedge fund basis trade volumes and bilateral repo volumes to gauge leveraged investors' demand changes; analyzing traditional funding suppliers' behavior through bank balance sheet data and weighted average maturities (WAM); and assessing market structure and intermediary capacity changes by tracking dealer positions and regulatory indicators. This multi-angle approach provides a more comprehensive and credible analysis of the reasons behind the weakening repo rates.

Methodology notes

• Industry/Industry Analysis FrameworkSupply-demand framework

  Short-term funding market rates (e.g., repo rates) are primarily determined by the supply and demand of funds (collateral)

  In this report, the core analytical approach follows the 'supply-demand' line. By examining changes in the behavior of different market participants (hedge funds, banks, GSEs, MMFs), the institution assesses whether they are increasing or decreasing their demand/supply of repo funds, thereby explaining the rate movements.

• Fixed Income & Credit AnalysisSpread analysis

  Focus on changes in the difference (spread) between different interest rate benchmarks, rather than absolute rate levels

  The report focuses on changes in the spread between SOFR relative to IOBR and EFFR. This relative value analysis provides a better indication of the true tightness and pricing anomalies in the short-term funding market than simply looking at SOFR's absolute level. This method is a common tool in fixed income market analysis.

Key data

• 20-day moving average spread of SOFR relative to IOBR-7bpIndicates repo rates have remained below the Fed's managed interest rate lower bound
• Cash-futures basis trade volumesApproximately $13.5 trillionDecreased by approximately $15 billion from previous levels, the lowest in over a year
• Total MMF asset size$82.81 trillionReached a record high, indicating ample available cash for lending
• Year-over-year growth rate of U.S. large banks' Treasury holdingsNear the lowest level in two yearsReflects slowed Treasury purchases due to uncertainty in the interest rate path

Impact & implications

The report concludes that the combined effect of these factors has kept repo rates at extremely low levels, supporting the trading logic of taking a long position in the 2-year U.S. Treasury swap spread, as a more accommodative funding environment typically pushes up front-end swap spreads. Additionally, the relaxation of regulatory constraints (such as eSLR reform and potential GSIB adjustments) is expected to enhance dealers' intermediary capabilities and market resilience, which will help improve the operational functionality of the Treasury market in the long term.

Risks

• If fiscal stimulus measures are implemented before the midterm elections, it may push up short- to medium-term inflation expectations, posing a risk to the recommended yield curve flattening trade; if the labor market stabilizes or the funding environment becomes tighter than expected, it may pose a risk to the long position in front-end swap spreads.

What to watch

• Specific implementation details of the newly proposed GSIB regulatory rules and their impact on incentives for banks to hold Treasuries or engage in repo intermediary activities.
• The evolution of the Fed's interest rate path, as it will continue to influence asset allocation decisions of major market participants such as banks and MMFs.