We went down the rabbit hole (again) with Jeff Snider, this time to figure out why everyone is talking about Reverse Repos (RRP).
After one email exchange, it was clear that few people actually know why this chart matters (classic FinTwit), so we put it to our contributor network and asked them all the same question, “Why Does This Chart Matter?”
To the standard RRP chart we added US Treasuries because, as Jeff pointed out, RRPs as a standalone statistic doesn’t tell the whole story. We can see on the chart that, on March 18th, right when yields went from reflationary to not reflationary, RRPs picked up, did not come back down to zero as they have always done, and then made their historic run up to today (as of June 14th they sit at $584 billion).
This time around, our contributors’ responses are closely aligned, but each adds their own valuable nuance (which is the exact reason we started this chart's publication).
Jeff Snider | Alhambra Investments
- Conventional theory holds that reverse repo use is a monetary policy accommodation to drain an excess of bank reserves from an overly abundant system. This was how it was used in 2008. But like 2008, there is more going on that has less (if not very little) to do with bank reserves and much to do with collateral scarcity for global repo and derivatives markets. [Editor’s Note: in a reverse repo, corporate and depository institutions receive collateral]
- Briefly, the combination of QE along with Treasury refunding of bills further combined with increased risk aversion left the global monetary system with scant collateral options. [Editor’s Note: with the ‘system’ telling us it’s collateral scarce, i.e., it’s fragile]
- This is why - and the only way - there can be an almost perfect positive correlation between reverse repo use and anti-reflation in bills and LT UST's. [Editor’s Note: this is why we see RRP begin to pick up on the same day that yields begin to flatten and eventually reverse (anti-reflationary)]
- "Too much money" would not produce this effect, one being replicated in markets like Eurodollar futures, too. [Editor’s Note: it’s not about too much money, it’s about not enough collateral]
If you want to see how deep the rabbit hole goes, take the red pill and enjoy the following content from Morpheus… I mean Jeff:
- Emil Kalinowski & Jeff Snider: The Fed's Reverse Repo Program Surges!
- Reserving Observations On The Reverse Repo Of Reserves
- No Reserving Interpretation About Reverse Repo Collateral Connection(s)
Mike Green | Simplify
- The March date matters because this is when the Fed ended the increase in counterparty limits it enacted on a temporary basis in 2020 as the COVID pandemic hit. The ending of the increased limits meant that banks now must hold equity capital against reserves which incentivizes them to “get rid of them” in the overnight market. This increased incentive had the potential to drive rates permanently negative in the overnight market. So the Fed had to be willing to take them rather than force the banking system to absorb them. This gives us the mechanical explanation of what occurred.
- However, the second critical insight is that this is likely to continue to grow due to quarter end dynamics on June 30th. On this date, offshore banks with US branches have a “window dressing” event that incentivizes them to reduce leverage. That spike is likely to create some turbulence in the market unless the Fed aggressively supports market liquidity.
- Finally, this chart calls into question the concept of an aggressive recovery – the banks see limited use for reserves. In other words, loan demand remains weak.
Luke Gromen | The Forest for the Trees
- In the context of Basel 3 banking regulations regarding bank reserves, Fed QE has led to a situation where there is too much cash chasing too little collateral; this has put downward pressure on short-term interest rates.
- The spike in RRP balances is a symptom of the Fed acting (Reverse Repo-ing USTs) to make sure short-term rates stay positive (as negative rates would likely cause severe problems in monetary “plumbing.”)
- The spike in RRP balances is a “Band-Aid fix” – more structural options include tapering QE, having the US Treasury shift issuance to the short end, have the Fed shift QE to the long end, or have the Fed implement a Standing Repo Facility.
- A Standing Repo Facility would likely effectively nationalize US funding markets, which would likely NOT be deflationary or disinflationary.
Seth Levine | The Integrating Investor
- The large spike in overnight repo demand illustrates the (frantic) demand for banking collateral within the financial system. Remember, today's financial system runs on collateral and not traditional central bank reserves. This is a market innovation and evolution away from central bank controls. The plateauing of treasury yields also supports the view of growing collateral demand.
- In March, banks were again required to hold capital against central bank reserves and treasuries. This likely created increased demand for collateral.
- However, this change coincided with increased business and lending activity. Growing businesses require capital and today's lending environment is fueled by collateral. Note that repo spike and tapering treasury yields coincide with the regulatory change, strong PMI prints, drop in COVID cases, and robust reopening trends across the US.
- While caution is warranted, I'm not sure that we're seeing the musical-chairs grab for quickly evaporating collateral like in the Great Financial Crisis. Rather, the aggressive restarting of life from a near-standstill may be catching lenders off guard at the very same time the Fed changed the rules. The catastrophe may be missed profit opportunities rather than financial collapse.
- Collateral has once again become an issue. Banks can't lend and customers can't borrow unless they can source collateral to back the loans.
- Therefore, banks are depositing their spare QE proceeds with the Fed because of a lack of other opportunities.
- US 2-Year yields have hardly budged for the last few months and demand for longer dated bonds as collateral has capped yields on the 10-Year. Also, the US Treasury is drawing down from the General Account rather than issue new bonds, exacerbating the issue.
- It’s unlikely that we can see true inflation beyond base effects and bottlenecks if banks aren't willing to lend and customers aren't able to borrow.