A Tsunami Of Take-Ups In The Fed's O/N Reverse Repo Facility Nullifies QE, Tightens Systemic Liquidity

Unless an investor has been staying under a rock in the past several weeks, she/he would have read about the case of a tsunami of cash that was headed, and is still heading, for the Federal Reserves' Overnight (O/N) Reserve Repo facility (O/N RRP) to find a home (see Chart No. 1, below). In a reverse repo transaction, the Fed sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. It is analogous to putting up money for deposit in a bank, but where the bank gives you back Treasury securities as collateral.

Chart No. 1

Reverse Repo operations have always taken out liquidity from the financial system and have been used by the Federal Reserve as one means of tightening monetary policy when done in large scale. But the history of O/N RRP's use as a tool to tighten financial conditions has been episodic, so it is not clear if this recent surge in volumes of take-ups in reverse repo matter as tightener of financial liquidity today. So we ask: does the current tsunami of take-ups in the Fed's O/N Reverse Repo facility matter, as tightener of systemic liquidity?

We say, yes, it does matter -- a lot. Changes in the O/N RRP take-ups tend to lead changes in SPX and VIX (see Chart No. 2, below). But the negative effects materialize only after a long time lag, so investors have to be on the lookout for it. We explain in detail in this article why the deluge of cash heading for the O/N RRP in the foreseeable future tightens systemic liquidity and may trigger market "dislocations" no one expects. But we say that wait for another two weeks, or three, and the market will start talking about how the market will react badly to it.

Chart No. 2

The Fed is still buying about $120 billion per month in Treasury securities and mortgage-backed securities, thereby adding systemic liquidity. But with the take-ups in the O/N Reverse Repo facility of $670 billion (to date), the Fed undid almost 6 months of Quantitative Easing. The Fed does stealth Quantitative Tightening (QT) with the O/N RRP. And it looks like this situation will continue for the foreseeable future: ZeroHedge reported today that Money Market Funds (MMFs) see massive inflows as investors turn defensive, and those MM funds have nowhere else to turns to, but the Fed's O/N RRP facility. The O/N RRP pays out zero percent (0%) interest, but that is a lot better than funds paying negative rates in the money markets (investors pay interest on funds placed).

When the Fed conducts QE, that mechanically expands the size of the banking system's aggregate balances sheet (with Bank Reserves), but some of that "money" can also be absorbed by the Treasury General Account (NASDAQ:TGA), the US Treasury's checking account at the Fed. The TGA has expanded to $1.831 trillion by July last year when the Treasury "stockpiled" cash at the TGA in anticipation of COVID-19 relief measures. That did happen, but not to the extent anticipated by the Treasury, so most of the remaining cash has to be drawn down to comply with regulations. There will still be a massive cash outflow from the TGA (see Chart No. 3, below) following the mandates of the US Treasury.

Chart No. 3

Hundreds of billions in cash will be released from the Treasury's Treasury General Account ("TGA"), see Chart No. 3, above. The TGA has declined to $779 billion so far, so more drawdown is coming. Those funds will go looking for a home to park as well -- and there is no choice now, but to gravitate to the O/N RRP facility. Funds from TGA will be flooding into the O/N RRP until there's only $500 billion left in the account, maximum, by end of June 2021.

How does this massive flood of cash to O/N RRP pose systemic risks?

How does systemic liquidity tightening happen in this case? Here is how the ON/RRP take-outs reduce Bank Reserves. Envision it from the top-level -- how assets and liabilities of the Fed's balance sheet (SOMA) interact (see Chart No, 4, below). O/N RRP is a General Collateral operation, so lenders to the facility are provided by the Federal Reserve Treasury collateral in the take-ups. Money market and GSE (Government-sponsored Entities) funds are placed into the O/N RRP, and the Fed issues those investors Treasury securities as collateral for those placements.

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Disclosure: I am/we are long SPY, IWM, DIA, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with ...

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