The Federal Reserve building pictured in Washington, U.S., July 16, 2018. REUTERS/Leah Millis

By Gertrude Chavez-Dreyfuss and Laura Matthews

NEW YORK (Reuters) -A sizable block trade in the U.S. rates market late last week appeared to be positioning ahead of the Federal Reserve's expected announcement to finally end its long-running balance sheet reduction program, known as quantitative tightening (QT).

CME Group data showed a huge block trade last Thursday of 40,000 contracts that expire in November, a wager that the Secured Overnight Financing Rate (SOFR) - an overnight repo rate - will average less than nine basis points above the expected federal funds rate, the U.S. central bank's benchmark rate, in November.

The trade marks a departure from this year's trend and reflects growing expectations that the Fed will announce the conclusion of QT at the end of its policy meeting on Wednesday.

SOFR, currently at 4.24%, is the overnight borrowing rate for short-term cash mostly secured by Treasuries as collateral. The fed funds rate, currently at 4.11%, is the cost of unsecured overnight loans banks charge each other to meet reserve requirements.

According to traders, the 40,000 contracts suggested that the position would gain or lose roughly $2 million for each basis-point move in rates. This measure of interest rate risk is known as "DV01."

It's a massive position, analysts said, given that the trade's exposure is almost purely a one-month rate spread. Analysts said this trade's rate sensitivity is roughly equivalent to holding $2-$3 billion in 10-year Treasuries.

Essentially, the trade implied SOFR will average less than 3.95% and the Fed's policy rate will be 3.86% or higher in November as it follows through with its expected quarter-percentage-point rate cut at its two-day meeting this week.

That's the complete opposite of what the forwards market is suggesting. One-month forwards last Friday showed that traders expect SOFR to trade 9.5 bps higher than the fed funds rate by the end of November, suggesting still tight repo funding conditions.

"It's a trade that plays into the view that the Fed will stop QT (this week) and announce new policies to calm funding markets, allowing SOFR to come down from current levels relative to fed funds," said Steven Zeng, U.S. rates strategist at Deutsche Bank.

Fed Chair Jerome Powell said on October 14 that the central bank is ready to end QT, citing tighter liquidity conditions, including firmer repo rates.

Periods of QT often coincide with higher repo rates because when Treasuries and agency securities mature, they are not reinvested by the Fed. The Treasury redeems the debt and pays the central bank by subtracting the required amount from the cash balance it holds on deposit at the Fed.

That process drives repo rates higher as the Treasury withdraws liquidity from bank reserves to repay the Fed, reducing the cash available for overnight lending by banks and money market funds.

LOWER REPO RATES AS QT ENDS

When QT ends, the reverse happens. The decline in reserves halts, or they may even start to rise as the Fed reinvests maturing securities, leading to more liquidity in the system and lower repo rates.

Repo rates have also risen due to a number of other factors, including aggressive bill issuance by the U.S. Treasury to build its cash balance after the debt ceiling was lifted over the summer. The increased bill issuance has raised the need for repo financing to absorb all those Treasuries in the market.

Jonathan Cohn, head of U.S. rates desk strategy at Nomura, echoed Deutsche's Zeng in attributing the motivation behind the SOFR-fed funds trade to the Fed's balance sheet dynamics. He also noted some expectation that the central bank will most likely "backstop liquidity, say, by injecting reserves back into the system or offering lower rates on their liquidity release operations."

Since the middle of October, SOFR has consistently hovered near the upper bound of the Fed's 4.00%–4.25% policy rate range, even briefly exceeding it on two occasions. It has traded above the fed funds rate since August 22 and, prior to that, had outpaced the central bank's benchmark for much of the year.

Jan Nevruzi, U.S. rates strategist at TD Securities, believes the CME trade likely wasn't solely driven by QT. Instead, he sees it as a reflection of stretched valuations evident throughout the year, suggesting the investor was probably "fading levels."

Ideally, SOFR should trade below the fed funds rate, as it is backed by Treasuries and carries minimal credit risk. In contrast, the fed funds rate reflects unsecured interbank lending, which involves counterparty risk. As a result, lenders in the fed funds market typically demand a slightly higher rate than SOFR to compensate for that risk.

Last Friday, however, SOFR was 13 basis points above the fed funds rate - an unusual inversion that underscores shifting forces in short-term funding markets.

(Reporting by Gertrude Chavez-Dreyfuss and Laura Matthews; Editing by Paul Simao)