Reverse Repo Explodes

Trouble ahead?

Yesterday’s WSJ ran this headline: Credit Suisse’s #Zoltan Warns of Trouble Ahead in the Money Markets. If you saw the article you might have asked, as I did: “Who is #Zoltan and why does he think there is trouble ahead in the money markets?”

If you opened the WSJ article, you would have learned that “investors have started storing hundreds of billions of dollars at the Federal Reserve each night, and no one is quite sure what it means.” Hundreds of billions of dollars have rapidly moved out of the capital markets into the Fed and no one seems to know what it means, except possibly an analyst at Credit Suisse named Zoltan Pozsar? When this happened to the banks in 2008, we shortly thereafter had a global financial crisis on our hands. What’s going on here? Shouldn’t we all be better informed about this matter and at least a little bit concerned?

Digging a bit deeper, I learned that hundreds of billions of dollars have in fact recently moved into “reverse repos”, which are loans to the Federal Reserve (mostly overnight loans) collateralized by UST-bills and other securities owned by the Fed. This cash came from various sources, including commercial bank reserves, the GSEs (Fannie and Freddie for example) and the Treasury General Account. (The Fed now holds all the UST’s cash reserves, some of which used to be held by commercial banks.). And some of this cash, perhaps a large share, came from money market funds (MMFs) which like banks can now engage in repo activity directly with the Fed.

On June 17, the Fed announced that it was increasing the rate that it pays on reverse repo (RRP) from zero to 5bp. No that “5bp” is not a typo. We are talking about an annual interest rate of 0.05% (five one-hundredths of one percent) on cash lent to the
Fed on a collateralized basis. This doesn’t seem like much of a change, does it? No, but it is an infinitely large percentage increase from zero and following this rate increase some $300bn+ of cash quickly shifted into overnight RRP, taking the daily total to about $850bn, equal to 15% or so of the total repo market. In money market terms, this is a big deal. But what exactly is happening here, and why?

I am by no means an expert on the money markets, let alone reverse repo, but I know a lot more about this subject now than I did when I woke up this morning. (I wish I could say this about most matters in my life.) Bottom line, it looks to me like one (or more) of several things might be happening here. The Fed has said that its RPP repricing was a technical operation designed to help it manage the fed funds rate and that it worked as intended. (The federal funds rate is the rate at which banks lend each other excess reserves held on deposit at the Fed, and it is the primary “policy rate” targeted by the Fed, which it implements via its “open market” operations, ie repo). But perhaps something is also happening with the way in which commercial banks manage their large and growing cash balances (complements of the Fed’s various stimulus packages), which the banks can’t seem to lend out profitably to their borrower customers. Or perhaps this is simply a case of a short-lived money market arbitrage opportunity resulting from the Fed’s surprise move to increase the RRP rate from zero to 5bp, at a time when overnight T-bills (and private market repo) yielded 1bp. Or finally, perhaps something more noteworthy is going on with the perceived credit risk in the economy, which is incentivizing money market funds and other financial institutions to seek the safety of overnight collateralized lending to the Fed in lieu of making short-term loans to businesses, consumers and other financial institutions.

I am not sure how to evaluate each of these claims, but let’s examine them together to see if we can’t make more sense of this. I am going to skip the Fed operational aspects, which are pretty technical and largely outside the scope of this newsletter.

The WSJ article seems to suggest that the big increase in RRP reflects something significant (but largely unexplained) that is happening as a result of the big influx of (unwanted?) cash into the banks. The banks in turn hold this cash on deposit at the Fed in the form of “excess reserves”, pending other uses for the money such as increased loans or short-term investments. I don’t fully understand this argument, but I would note that the Fed currently pays an annual interest rate of 15bp on excess reserves, which was increased from 10bp in mid-June, when the RPP rate was also increased by 5bp. I see no reason why a commercial bank would lend their excess cash to the Fed via RRP for 5bp rather than just leaving it in their reserve accounts at a yield of 15bp, but perhaps I’m missing something. (Readers, please tell me if I am.)

As for the arbitrage argument, this may well be true but if so it will likely prove to be a short-lived phenomenon and this story another big nothing burger. (Recall all the doomsday news articles from September 2019, when the overnight repo rate jumped to 10%, catching the market and the Fed off guard? No, neither does anyone else other than money market professionals, a few financial reporters, some Fed staffers and of course oddballs like yours truly. But you can read about it here.) Returning to the arbitrage argument, when the Fed raised the RRP rate to 5bp last month (mid-June). the yield on USTs (and private market repo) quickly moved to this same level, eliminating the arbitrage entirely. This of course is what is supposed to happen, and usually does, in efficient capital markets. Nothing special going on here.

But what about this third argument—the “canary in the coal mine” thesis—that the big move into RRP signals an impending change in the credit quality of banks and other financial institution counterparties and/or money market securities (including non-UST securities used as collateral in private repo transactions.) I am not endorsing this argument, made by George Gammon and others (see video link below), but I suppose it is not implausible given the near-zero rates of interest paid on money market securities (5bp on UST bills, 8bp on 1-year CDs, 12bp on AA financial CP). At these low yields, there isn’t much upside to the money market investor in taking even a trivial amount of credit, counterparty or liquidity risk. And if money market fund managers perceive an uncompensated decrease in the credit quality of their financial institution trading counterparties or the securities they post as collateral, then it may make sense quickly to move their cash into RRP and lend it to the Fed with higher quality collateral, at least for the time being. A safe port in an impending storm if you will.

But where is the impending storm? If a storm really were approaching, wouldn’t this be obvious to all of us? If not, wouldn’t we at least observe some increase in the pricing (credit spreads) on a range of securities that would presumably be effected by the same concerns, eg money market securities, leveraged loans, etc? To my knowledge this is not currently happening in the capital markets. I suppose it is possible (though unlikely) that a select group of particularly clairvoyant money market investors accurately perceive increased risks in the money markets which other investors simply haven’t yet woken up to. And if this is the case, I suppose some of them might look to park at least some of their cash with the Fed temporarily.

I am reminded here of the scene in The Big Short when Dr. Michael Bury explains the “obvious" impending disaster in subprime to one of his investors, who wants to withdraw his money from Bury’s fund, which is rapidly losing money because the capital markets haven’t yet woken up to the full ramifications of the housing crisis. “There are markers, there are always markers”, says Bury. “I may be early but I’m not wrong”. Well yes he was early, and no he wasn’t wrong. So maybe something similar I going on now with RRP. You can watch the Big Short scene here. Trigger alert: lots of f-bombs in this one!

But even if we accept this argument, where might the increased risk be coming from? Isn’t the US economy currently going gangbusters, as I described in my recent blog post, “The Economic Recovery: Finally some good news”? Aren’t the US capital markets awash with liquidity and credit due to hyper-accommodative Fed monetary policy? And aren’t US businesses and households flush with cash due to the $2+ trillion dollars of government largesse distributed during Covid?

Yes all of this is true, and I am not suggesting that the US economy won’t continue to strengthen for some time yet. But what if some of these seemingly encouraging economic metrics—this metaphoric light at the end of our economic Covid tunnel— might just possibly be the light from an oncoming train? Recall that unlike Dr. Bury and the other hedge fund characters from The Big Short, very few investors (or regulators) actually saw the great financial crisis coming until it was upon us in full force.

This sort of disaster scenario may not be likely—and I don’t think it is—but if you are a money market investor earning single-bp annual returns, why take any risk at all? Keep in mind here that many of the large (and so far successful) government benefit programs which have kept the US economy afloat during Covid now have either terminated or are scheduled to end soon. What will happen when we no longer have this unprecedented amount of government subsidy buoying up the US consumer and the economy?

Think for example about the estimated 8mm households (that’s households, not individuals) who have not been paying their mortgages or rents for some time and who will start to be evicted from their homes once government foreclosure and eviction moratoriums end. US mortgage foreclosures are currently at an all-time low—seemingly a bullish economic statistic—but this may be attributable in significant part to the foreclosure moratoriums and all the “Covid cash” piling up in the accounts of households who may not have been paying their bills. Viewed this way, that light at the end of the tunnel (low mortgage foreclosures) might well be an oncoming train (a big rise in defaults and evictions). How real is this threat? How much damage might this do to the financial markets and the US economy? What other similar (or dissimilar) risks might also be lurking around the corner?

I really have no idea, but I put this out there for you all to consider. The purpose of today’s post isn’t to give you the answers, or to alert you to some impending economic disaster, but rather to bring to your attention something interesting and potentially significant which is happening in the capital markets and which very few people are talking about, other than our friend Zoltan at Credit Suisse, a reporter from the WSJ and some guy in an unbuttoned shirt on a YouTube video (George Gammon).

I think this is a “teachable moment” and I hope you will spend some time on this important, albeit esoteric, topic.

For those of you who do care to learn more about the intricacies of reverse repo, here are three links that you might find interesting:

WSJ, Credit Suisses’ #Zoltan Warns of Trouble Ahead in the Money Markets

Credit Suisse, Global Money Dispatch, Zoltan Pozsar

Financial YouTube, Reverse Repos Explode, George Gammon