A major source of liquidity for buying U.S. government debt is draining. Here’s why that’s bad news for the Fed and the market.

A Federal Reserve repo facility is back in focus as a gauge of liquidity as U.S. stocks stumble and investors brace for another barrage of Treasury borrowing to fund the U.S. government’s large budget deficit.

Funds parked by institutional investors short-term at the New York Fed’s overnight reverse repo facility have dropped to $1.1 trillion from a peak of about $2.5 trillion in December, according to Fed data.

It…