Beware of the Reverse Repo

I’ve been seeing a lot of headlines about the Federal Reserve’s ‘Reverse Repos’ and the impact they are having on the broader financial markets. This all sounds complicated so here’s a quick explainer on what they are, what’s happening now and why I think it’s important.

The Fed sets the Federal Funds Rate

People normally assume the Fed sets interest rates. What it actually does is set the ‘Fed Funds Rate’, which is the rate that inter-bank lending occurs. This then has a secondary impact on the interest rates that normal consumers are charged (on things like car and business loans).

The Federal Funds Rate is determined by the demand for cash reserves (by banks). The Fed controls that through two key operations:

(1) Overnight Repo’s

(2) Interests on reserve balances (IORB)

Overnight Repo agreements are the way the Fed injects money into cash balances that banks hold. Banks can sell assets to the Fed overnight, with an agreement to repurchase those securities the following day. This temporarily increases the supply of money in the economy.

The Fed also holds reserves for major financial institutions. It can directly set the interest rate on those reserves balances (IORB). The net impact of this is to increase/decrease available money supply in the economy.

What is the Reverse Repo Program (RRP)?

The Reverse Repo Program is the opposite of the Overnight Repo (mentioned above). Instead of injecting money into the system, it takes money out. The Fed would sell Treasuries to eligible firms (banks, money market funds) and then agree to buy them back at a later date for a fixed return.

Why does the RRP exist?

The RRP is a short-term solution to their being too much money in circulation and resultingly, prevents the Fed Funds Rate from falling below the Fed’s target (Remember: if there’s too much money in circulation, then the supply of reserves overwhelms demand and banks end up lending to each other at even lower rates).

What is happening?

RRP Volumes

The volume in the RRP has gone up considerably and is hitting near record highs, despite the effective interest rate on these transactions being 0%. The volume in the RRP on Tuesday of this week, was at a staggering $433bn. That’s more than the entire GDP of Ireland. This is the highest transaction volume we have seen since 2019 and the third highest on record.

The irony is that the Fed is pumping $120bn/mth into the US economy and is effectively taking out three month’s worth of this in these overnight RRPs.

What does this indicate?

In short, that there is simply too much cash circulating in the banking system. For context, the Fed has spent $2.5tn since the pandemic (buying US Treasuries amongst other assets). The issue is that whilst this has added liquidity to the financial system (as sellers of Treasuries now get cash to sell their assets to the Fed), they then need somewhere to put that cash, other than effectively giving it back to the Fed.

The worrying thing about this cash going into RRP’s is that it means that (1) banks are simply not finding enough attractive places to park this cash (outside of the Fed) and/or (2) they are stepping down purchases of the US Treasuries (which is leaving them longer cash balances).

Bank Reserves held by the Fed

Why am I concerned?

What is concerning is that this is simply not sustainable. If there is too much cash going back to the Fed (even at 0% interest rates), the Fed is going to be forced to taper it’s purchases of securities and/or look to increase interest on reserves it holds.

The second issue is that with so much cash, there’s less money flowing into US Treasuries. Whilst this isn’t necessarily bad, the impact of banks buying less US Treasuries is that the yields/interest rates on those Treasuries go up.

At this point, it is almost certain that the Fed will need to take some sort of action. They will either raise the IORB or increase the overnight rate on the RRP (to keep it in line with their targets). Unfortunately, those efforts will likely attract more money back to the Fed = take more money out of the financial system. It therefore makes it impossible for the Fed to continue pumping more money into the system (if that is basically being returned back to it).

Rising rates and tapering will undoubtedly have a direct impact on the US financial system and the prices of assets that are particularly rate sensitive, such as houses, cash flow negative stocks and bonds.

What is next?

Whilst I don’t think we’re due for a large scale market sell off on the back of Fed tapering (mostly because the idea of tapering has been frequently discussed), it does make me more wary that short term corrections and pull backs are going to be more frequent, particularly in large cap tech (which has, so far, been shielded from a major correction).

As a result, I will be looking to expand future posts to cover some larger names that I will be looking to add positions to, particularly if those companies come under pressure in the run up to the next Fed meeting on June 15th.

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