The Fed Is Mopping Up Its Own Mess in Reverse Repo
(Bloomberg Opinion) -- Over the past couple of weeks, I’ve been tweeting near-daily updates of the following chart, which shows the amount of cash placed at the Federal Reserve’s overnight reverse repurchase facility. Use soared to a record $485.3 billion on Thursday, capping an unprecedented surge:
What I learned is that few people understand what’s going on here. And I don’t blame them. Some assume this is just the U.S. central bank printing more money — after all, the hot topic among Fed officials lately has been about when to start talking about reducing its $120 billion of monthly bond purchases. But it’s actually the opposite: The facility is a place for money-market funds and other counterparties to place excess cash with the central bank in exchange for a 0% interest rate.
Why is there so much demand for something that pays nothing? Because the alternatives are worse. As Bloomberg News’s Alex Harris reported on Thursday, the going rate on overnight general collateral repurchase agreements opened at -0.01%, and the bid-ask spread was 0%/-0.2%, making the decision to go to the Fed something of a no-brainer. Meanwhile, the U.S. Treasury’s four-week bill auctions began coming in with a yield of 0% at the end of April and hit 0% again on Thursday. Eight-week bills now yield 0.005%. In the secondary market, bill yields are sometimes negative. With choices like that, a 0% overnight rate at the central bank makes the most sense.
Understanding why banks, government-sponsored enterprises and money-market funds are willing to accept a 0% rate on their cash is probably the easy part. Nailing down exactly why there’s so much cash, on the other hand, involves several moving parts. And put together, it’s clear that this glut was exacerbated by Fed decisions over the past several months that the central bank is now left to clean up.
First, there’s something called the Treasury General Account, which is basically the government’s bank account at the Fed. Here’s what that chart looks like:
The account balance has been declining as the Treasury disburses fiscal aid to fight the Covid-19 pandemic and prepares for the debt ceiling to come back into play later this year. Often, as was the case recently with stimulus payments to state and local governments, that cash makes it way into money-market funds, which then need to invest it somewhere. As the previous look at front-end rates clearly showed, reverse repo is an obvious choice.
Treasury’s swift reduction in its cash balance shouldn’t have surprised anyone. I wrote in December that short-term rates were headed for zero and that the Fed might have to intervene, perhaps by selling short-dated Treasuries outright to counter a decline in bill issuance. Yet the central bank hasn’t done much to tweak its bond purchases, which are advertised as a way to provide accommodative monetary policy on top of near-zero interest rates and won’t be touched until the economy makes “substantial further progress.” Policy makers chose not to shift the buying away from the front end, knowing what was coming down the line.
Another problem with barreling forward with bond buying on autopilot, as was made clear during March when markets were fretting about the supplementary leverage ratio, is that it’s overwhelming some of the biggest U.S. banks. They don’t want any more reserves because it means they need to hold more capital, but that’s exactly what happens when the Fed is adding so many assets to its balance sheet (reserves at the Fed are the offsetting liability).
So, naturally, the only thing left for primary dealers to do was to scale back on their Treasury holdings:
Again, this was the natural result of ending the SLR exemption. I wrote in March that it looked as if the Fed was trapped, suggesting that perhaps a middle ground would be allowing reserves and Treasuries accumulated during the pandemic to be exempted. Instead, policy makers opted for a clean break, even as bankers like JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon raised the prospect of these regulations forcing them to turn away deposits.
It wasn’t an empty threat: reportedly some banks are doing just that. That cash instead gets redirected toward — you guessed it — money-market funds, which need to invest it somewhere. Yet again, there’s the Fed’s reverse-repo facility ready to absorb it. As of mid-March, it increased its limits to $80 billion per counterparty from $30 billion. It “reflects the growth and evolution of U.S. dollar funding markets since the limit was last changed in 2014.” On Thursday, the Fed added two more money-market funds to its approved list, from T. Rowe Price Group and Vanguard Group. Fidelity Investments has 11 funds that are reverse-repo counterparties. Even quant pioneer Dimensional Fund Advisors has one.
It’s unclear whether the Fed can do much to slow this pickup in the use of its reverse-repo facility. It’s also quite likely that central bankers don’t see it as a problem. Remember, it allows the central bank to defend the so-called zero lower bound of short-term rates. So far, it’s accomplishing that task, with the fed funds rate steady at 0.06%. Rather than force even more reserves onto banks, which can’t make enough loans relative to deposits, persistently huge reverse-repo operations are a tidy solution to soak up all the cash that’s seeping out into money markets, especially with funds content to earn nothing for now.
Still, central bankers might eventually give in and raise the so-called administered rates that the Fed pays at its reverse-repo facility and on excess reserves (IOER). The fact that they haven’t yet done so potentially suggests some concern about the optics of raising rates, even if it’s for technical reasons. But the prospect of money funds closing to new investors or offering negative returns, as suggested by Bank of America Corp. strategist Mark Cabana, might be seen as enough of a systemic risk to force their hands.
For now, though, the startling reverse-repo chart can be viewed as a mess created by the Fed that it’s mopping up itself.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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