The Reverse Repo Tsunami
Each new crisis brings with it a new suite of monetary tools for the unelected technocrats to experiment on the masses with. The latest and most popular tool deployed by the Federal Reserve is it's overnight reverse repurchase facility (ON RRP). What is it and how did it become so popular? How does this policy essentially undo the interventions of quantitative easing and what does this mean for the future?
A . Repos & Reverse Repos
To better understand the mechanics, the New York Fed describes their repo and reverse repo operations as the following:
Repurchase agreements (also known as repos) are conducted only with primary dealers; reverse repurchase agreements (also known as reverse repos) are conducted with both primary dealers and with an expanded set of reverse repo counterparties that includes banks, government-sponsored enterprises, and money market funds.
Below is the current list of primary dealers as of August 14, 2021. The expanded set of reverse repo counterparties includes the addition of some government sponsored entities and investment managers with money market funds.
Continued from the New York Fed:
In a repo transaction, the Desk purchases Treasury, agency debt, or agency mortgage-backed securities (MBS) from a counterparty subject to an agreement to resell the securities at a later date. It is economically similar to a loan collateralized by securities having a value higher than the loan to protect the Desk against market and credit risk. Repo transactions temporarily increase the quantity of reserve balances in the banking system.
In a reverse repo transaction, the opposite occurs: the Desk sells securities to a counterparty subject to an agreement to repurchase the securities at a later date at a higher repurchase price. Reverse repo transactions temporarily reduce the quantity of reserve balances in the banking system.
The New York Fed goes on to explain the purpose of the overnight reverse repo program. Bold emphasis added by me.
The Desk has conducted overnight reverse repo operations daily since 2013. The ON RRP is used as a means to help keep the effective federal funds rate from falling below the target range set by the FOMC. The overnight reverse repo program (ON RRP) is used to supplement the Federal Reserve's primary monetary policy tool, interest on excess reserves (IOER) for depository institutions, to help control short-term interest rates. ON RRP operations support interest rate control by setting a floor on wholesale short-term interest rates, beneath which financial institutions with access to these facilities should be unwilling to lend funds. ON RRP operations are conducted at a pre-announced offering rate, against Treasury securities collateral, and are open to a wide range of financial firms, including some that are not eligible to earn interest on balances at the Federal Reserve.
B. Quantitative Easing and COVID-19 Pandemic
The explicit goals of the Federal Reserve are to set U.S. monetary policy in accordance with its mandate from Congress: to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. Prior to the 2008 financial crisis, the Fed primarily utilized the federal funds rate to implement monetary policy. After dropping the federal funds rate to its lower bound of zero during the 2008 financial crisis, the Fed shifted its policy to focus on its System Open Market Account (SOMA). Through the Federal Open Market Committee (FOMC), the Fed would go into the marketplace and initiate large-scale asset purchases, also know as quantitative easing (QE). The Fed utilized QE to purchase massive amounts of Treasuries and mortgaged-backed securities (MBS); massively expanding its balance sheet and flooding the market with liquidity.
The immediate goal of QE is to stabilize the financial system by providing liquidity to failing financial institutions. This also has the immediate impact of pushing down interest rates; the Fed buying assets can artificially increase asset prices and reduce yields. Also, entities that are able to exchange their impaired assets at close to par value now have sufficient liquidity to avoid defaulting; this also dampens the risk of rising interest rates. Ultimately, more liquidity combined with lower interest rates are used to subdue increased volatility in the financial system.
QE has innumerable issues, but the primary concerns relate to the moral hazard of bailing out quasi-governmental entities, mispricing credit to cause malinvestments throughout the economy, and ultimately the economy's dependence of continued and larger interventions to keep the whole system afloat. The final outcome is a massive financial correction and the potential destruction of the currency.
Prior to the COVID-19 pandemic, the Fed was trending towards a policy of normalization. Although, there were major bumps in the road even prior to the pandemic. With the onset of the pandemic, government shutdowns, and financial markets tumbling, the Fed stepped in and massively intervened. You can see the huge scale of the intervention in the Total Assets FRED graph below; it dwarfs the once considered massive 2008 financial interventions.
In the first few months of the pandemic, the Fed increased its balance sheet by roughly $3 trillion dollars. The Fed had restarted almost every '08 financial crisis program along with starting many new programs. Indefinite monthly QE purchases ramped back up to $120 billion dollars per month; $80 billion in US Treasuries and $40 billion in MBS. Also, the Fed temporarily modified the calculation of key leverage ratios to help stabilize bank liquidity and the US Treasury markets. To learn more, check out our prior article on the supplementary leverage ratio. In addition, the Fed eliminated all reserve ratios of demand deposits - a key tenant of fractional reserve banking.
It has been almost a year and a half since the start of the COVID-19 pandemic and many of the Fed's interventions are still in place. Monthly QE purchases of $120 billion are still ongoing and short-term interest rates are still be held at essentially zero. Although policy normalization still seems to be still far off, inflation is ramping up and reverse repos have exploded. The most recent Fed minutes from July 27-28 continue to downplay inflation as a result of mostly supply issues and the term "transitory" is still in heavy usage.
Reverse Repo Tsunami
Reverse repurchase agreements with the Federal Reserve, reverse repos, occur when financial institutions exchange reserves to hold collateral and receive interest from the Fed. Another way to look at this situation, financial institutions are lending money to the Federal Reserve and holding the Fed's US Treasuries as collateral. The Fed then repurchases those US Treasuries and pays a small amount of interest on top. At the end of March 2021, reverse repos exploded and the dollar value of these transactions has marched relentlessly higher. In mid-August 2021, the daily value of reverse repos have surpassed $1 trillion dollars.
The massive amounts of liquidity sloshing around in the markets had been pressuring many key interest rates lower, with some fearing the potential of negative rates. One of the ON RRP's primary goals was to set the floor on interest rates at 0%. With rates being pushed lower, many financial institutions had begun piling into the reverse repo market to avoid negative rates. In addition, there has been a severe collateral shortage. As Reuters reports:
With the Federal Reserve in the midst of its quantitative easing program, the U.S. central bank has been buying Treasuries both on the short- and long-end and flooding the financial markets with cash.
In addition, the Treasury has reduced the supply of its bills in the market, exacerbating a collateral shortage that has prompted financial institutions to lend money to the Fed's reverse repo facility in exchange for Treasury collateral.
On June 16, 2021, the Fed announced adjustments to their overnight reverse repo facility. "Effective June 17, 2021, the Federal Open Market Committee directs the Desk to...Conduct overnight reverse repurchase agreement operations at an offering rate of 0.05 percent and with a per-counterparty limit of $80 billion per day; the per-counterparty limit can be temporarily increased at the discretion of the Chair..." The bold emphasis was added by me. The Fed increased the reverse repo rate from 0bps to 5bps and this is a huge development. The incentive is even greater for liquidity to find its way into the reverse repo facility. Reserves that were previously earning zero or close to zero are now incentivized to participate in this program to earn a risk-free 5bps. JP Morgan analysis has estimated that money-market funds (MMFs) and government sponsored entities (GSEs) have the most to gain from participating in the reverse repo facility. They don't have access to the interest on excess reserves (IOER) rate, which is 15bps, that banks have access to. Without an end to QE in sight, it is expected that the reverse repo facility will continue to grow as more liquidity is added to the financial system and it desperately searches for a positive yield. There could be some relief later this year when the US Treasury will issue new debt. Although, new Treasury debt is dependent on the debt ceiling being raised. After the Treasury General Account hit an all-time high at $1.8 billion dollars, the balance has been drawn back down to historically normal levels. Later this year, the Federal government will be low on funds and will need to issue new debt.
Ultimately, this is becoming a bit of an absurd loop. The Fed injects trillions of dollars of liquidity into the system by buying and removing the US Treasury supply from the market. All this excess liquidity drives down rates and causes a collateral shortage. The Fed then soaks up the liquidity and provides US Treasuries through its ON RRP. The only thing being accomplished though this process is the growth of control over the financial markets by the Federal Reserve.
In July 2021, the Fed announced that it would establish two new standing repo facilities; a domestic repo facility (SRF) and a foreign repo facility (FIMA repo facility). Per the recent press release, "These facilities will serve as backstops in money markets to support the effective implementation of monetary policy and smooth market functioning." This new facility will enable financial institutions to trade their collateral (Treasuries, MBS, and agency-backed securities) for up to $500 billion in reserves at a rate of 25 bps. These new facilities will give the Federal Reserve further control to dampen upward pressure on rates. This new repo facility had been discussed previously in articles on the St. Louis Fed. By having the ON RRP set the floor on interest rates (the Fed will always provide a positive rate) and having the SRF set the ceiling on interest rates (the Fed will always lend at a lower than market rate), the Fed is attempting to keep interest rates confined to a narrow approved range. If there were a crisis where there was too much liquidity and rates went negative, the Fed would soak up much of that liquidity by paying a positive rate and hopefully driving the market rate back into positive territory. If there were a crisis where there was an insufficient amount liquidity and rates were spiking, the Fed would provide the market with liquidity and hopefully pull the market rate lower. For shocks to the financial system relating to either too much or too little reserves, these tools might help to stabilize the system. There is still risk in the Fed selecting the incorrect approved range for interest rates to fluctuate within. Flooding or soaking up paper in the system might keep the nominal rates stable, but it ignores the intertemporal coordinating effects of interest rates.
We are living in a historic time with innumerable unprecedented interventions into many facets of everyday life. From lockdowns and mandates to massive fiscal and monetary interventions, there has never been such a large-scale effort to control every aspect of everyday life. We live in an age of scientific governing by technocrats and bureaucrats. Economies do not operate on physics-based rules. Economics is the study of human action. Scientific management of the economy is impossible as nth order effects can never be fully understood or anticipated.
What will the ultimate impact of these policies be? Will inflation remain transitory? Can the Fed ever normalize monetary policy without crashing the economy? Can ongoing massive monetary interventions be a sustainable long-term approach without major negative consequences? As noted in the most recent Fed minutes, "Participants anticipated that the Committee [FOMC] would learn more about how these facilities operate over time and noted that it could adjust some parameters of the facilities on the basis of that experience." We are all lab rats to a massive monetary experiment.