If You are in a Hole, First Stop Digging

By: Steve Sosnick, Chief Strategist at Interactive Brokers

Over the past few weeks, we have paid considerable attention to the growing Federal Reserve balance sheet, even as the Fed has been actively discussing the prospect of ending its open market purchases of fixed income securities. Despite the rhetoric, one other measure of financial liquidity remains similarly elevated – the levels of activity at the New York Fed’s Overnight Reverse Repo Facility (RRP).

In October we noted the rising levels of RRP activity as a bellwether of excess liquidity flowing through the system. The Federal Reserve defines the RRP in this manner:

“The Overnight Reverse Repo Facility (ON RRP) helps provide a floor under overnight interest rates by acting as an alternative investment for a broad base of money market investors when rates fall below the interest on reserve balances (IORB) rate.”

“The Federal Reserve manages overnight interest rates by setting the interest on reserve balances (IORB) rate, which is the rate paid to depository institutions on balances maintained at Federal Reserve Banks. The ON RRP provides a floor under overnight interest rates by offering a broad range of financial institutions that are ineligible to earn IORB, an alternative risk-free investment option. Together, the IORB rate and the ON RRP set a floor under overnight rates, beneath which banks and non-bank financial institutions should be unwilling to invest funds in private markets.”

In short, the Fed is acting as the depositor of last resort, using RRP to keep short-term rates from going negative. When banks and other financial institutions have excess funds they want to lend them at a positive rate of return. When those funds represent money that they hold in custody for customers, they need to lend that money to very safe creditors. The US government certainly fits that bill.

The heavy use of the RRP shows us that there is more money to be lent than there are places to put it. The Fed pays 5 basis points (bp) annualized on the overnight deposits. Banks wouldn’t lend them that money at such a measly rate if they had anything better to do with it. The chart below shows how usage of the RRP grew steadily last year from zero, and how it remains at elevated levels even as the Fed has publicly changed its stance about interest rates and quantitative easing (QE):

(Click on image to enlarge)

Source: Reverse Repo Operations – FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)

Prior to last year, the RRP was rarely used. It typically came into use only around quarter or year ends if banks had trouble lending excess funds around statutory reporting periods. This is evident if we view the same data on a longer scale:

(Click on image to enlarge)

Source: Reverse Repo Operations – FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)

While we have stopped setting near-daily records in RRP usage, (the peak was set on December 30^th, the last business day of 2021) we clearly continue to see RRP at extraordinarily high levels. Bear in mind that the point of the recent monetary accommodation and QE was to ensure that money was still able to flow unimpeded through a Covid-shocked economy. The hope was that money should have been used for necessary and/or productive purposes. But remember that classic economic theory holds that inflation is caused when too much money chases too few goods. At first, that excess money helped raise asset prices – something generally embraced by investors.  It now appears that the monetary growth has a key role in the rising prices of goods and services, however.  The onus is on the world’s central banks – who generally share a mandate to maintain stable prices – to reduce the excess liquidity in the system.

I have used this metaphor to describe RRP in relation to QE: the Fed has been filling the economic pool with money. At some point, they noticed that the pool was overflowing and decided to operate a pump for the overflow rather than turning off the faucet.

The continued, steady use of RRP is yet another sign that the Fed’s measures to reduce QE and remove monetary stimulus have not yet taken hold. If money were indeed getting removed from the system, we would certainly expect to see less need for over $1.5 trillion to show up at the RRP facility on a daily basis, seeking 5bp.I remain convinced that although we have seen market volatility increase as the Fed switched from a purely accommodative stance, we have not yet seen anything near a restrictive policy yet. And when we do, the volatility should persist.