Reverse Repos Surge but Watch Repos
1. INTRODUCTION
$992b was parked with the Federal Reserve via the Reverse Repo Program (RRP) on 30 June 2021, 109% higher than the pre-COVID peak. Reverse repos allow institutions, such as banks, to purchase treasuries from the Federal Reserve and resell those treasuries back, typically for a small profit. It essentially serves as a virtually risk-free option for institutions to park excess cash left over after exhausting all other appropriate investment opportunities. The surge in reverse repos has largely been driven by the ongoing quantitative easing (QE) program and signals there is ample liquidity in the market.
Inversely, the repo program allows the Fed to borrow assets off institutions and inject the additional liquidity required by short term money markets to function smoothly. The repo program was most active in September 2019 when the overnight repo rate spiked to 9% intraday, preceding a 4% correction in the S&P500 over the following fortnight.
2. WHY REVERSE REPOS SURGED
2.1. Relative Amount of QE
The main driver of demand for reverse repos is the excess liquidity created through QE where the Federal Reserve purchases treasuries to inject liquidity into the financial system. As the US economy recovered and emerged out of a recession, institutions were able to become less dependant on central bank stimulus. However, the pace of treasury and mortgage back security purchases by the Federal Reserve has yet to be tapered from $120b per month, creating excess liquidity in financial markets.
In April 2020, the pace of net asset purchases by the Federal Reserve was almost 6x the peak of the GFC response. Comparatively, reverse repo demand on 30 June 2021 was only double the peak during the post-GFC recovery. This implies that reverse repo demand is well within proportionate bounds and has room to continue rising.
2.2. Loosening of Regulatory Limits
Several regulatory limits were loosened to broaden participation in the RRP. Firstly, the daily per-counterparty limit was lifted by 167% to $80b, effective 18 March 2021. Secondly, the minimum net assets required was lowered on 30 April 2021, allowing for smaller institutions to participate in the RRP.
Additionally, the Federal Reserve increased the interest rate paid on reverse repos from nil to 0.05% p.a. on 17 June 2021. This increased the relative attractiveness of the RPP, which thus yielded more than some short-term treasury bills at the time.
3. CONTRIBUTION TO MARKET STRENGTH
3.1. Signals Ample Liquidity
The build-up in reverse repo demand is reflective of the ample amount of liquidity in financial markets. As institutions buy treasuries off the Federal Reserve via the RRP, it pushes down treasury yields which are inversely correlated to price. As we are in a bull market driven by liquidity and low discount rates, the reverse repo market can be a helpful gauge of market conditions. High reverse repo demand also suggests there is currently sufficient liquidity in the market to absorb a tapering of bond purchases or liquidity injections into the market by the Federal Reserve, should it occur.
3.2. Will not Prompt Tapering
Whilst high reverse repo demand indicates ample liquidity, it alone will not prompt the Federal Reserve to taper bond purchases. Markets are cognisant of tapering given the premature “taper tantrum” in 2013 which prompted a sharp rise in bond yields and a sharp correction in equity markets. In the Minutes of the June 2021 FOMC meeting, the Federal Reserve reiterated that “in assessing the appropriate stance of monetary policy, they would take into account … readings on public health, labour market conditions, inflation pressures and inflation expectations, and financial and international developments.” Hence, reverse repo demand is not an explicit factor considered. Additionally, there has been little to no discussion of reverse repo demand in FOMC meetings, suggesting it is not an area of concern for the Federal Reserve.
4. REPO RATES
4.1. September 2019 Repo Crisis
On 17 September 2019, a lack of liquidity in the overnight repo market caused the intraday repo rate to spike to over 9%, up from 2.2% the week before. The repo market is where institutions can collateralise treasuries to borrow from one another at close to no risk to fund short term capital needs. A healthy, functioning repo market is critical to an efficient allocation of financial capital. The spike in the repo rate also resulted in the effective cash rate rising temporarily to 2.3%, above the upper 2.25% limit imposed by the Federal Reserve.
Between 17 September 2019 and 2 October 2019, the S&P500 pulled back 4%. This was despite an immediate response from the Federal Reserve to purchase $72b in treasuries daily on average across the same period via the repo program to inject additional liquidity. The Federal Reserve has purchased $11.2t in treasuries via the repo program since 17 September 2019.
5. CONCLUSION
Surging reverse repo demand is a natural consequence of QE and signals there is ample liquidity in markets. Inversely, a spike in the repo rate is abnormal and signals liquidity problems in overnight funding markets. We continue to monitor both indicators to manage market risk in our portfolios.
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