Reverse Repos Hit a New Record High of $2.33 Trillion: Plus a Q&A on Free Money! – Mish Talk

July 6, 2022

Understanding Repos

A repurchase agreement or repo (RP) is an agreement between parties where a buyer agrees to temporarily purchase a basket or group of securities for a specified period.

The buyer agrees to sell those same assets back to the original owner at a slightly higher price using a reverse repo (RRP).

Understanding QE

The preceding paragraphs are confusing but think of repos and how Quantitative Easing works.

In QE, the central bank gives banks cash (cash that banks literally have no legitimate use for) and swaps that cash for securities, typically treasuries or Mortgage Backed Securities MBS.

In the process of buying securities, the Fed forced down yields on treasuries and mortgages goosing housing and the stock market.

As a result of all this asset buying, the Fed’s balance sheet rose to record highs.

Fed’s Balance Sheet

Fed’s Balance Sheet vis St. Louis Fed

Via QE, the Fed expanded its balance sheet, not by overnight or temporary purchases but via long-term actions or “coupon passes”. But it’s really the same swap idea, cash for assets.

The cash for assets swap left banks with trillions of dollars of reserves.

Reserve Balances at Banks

Reserve Balances at Depository Institutions courtesy of the St. Louis Fed

Quantitative Tightening

As noted above, QE (balance sheet expansion) is similar to a repo action but of longer duration.

QT (reduction in the Fed’s balance sheet) is the opposite. But QT can also be achieved by allowing securities to mature without rolling them over.

The Fed’s QT program, especially mortgages, is a runoff operation. The Fed will reduce its balance sheet primarily by runoff as opposed to outright sales of securities.

With that understanding, let’s return to reverse repos.

Reverse Repo Operation

The above chart is courtesy of the New York Fed.

Reverse Repo Operation June 30 Details

The Fed offered $2.39.7 trillion in reverse repos at 1.55%
There were 108 takers (nonbanks especially money market funds, banks, etc.)
The term was overnight.

Q: The takers took every penny they could get. Why?
A: Note the 1.55% rate. The 1-month T-Bill rate is only 1.33%

The current Fed funds rate is 1.50 to 1.75 but 1-month T-Bills yield only 1.33%.

Why not take 1.55% for as much as you can get instead of 1.33% especially when the Fed is going to hike rates, most likely to 2.25-2.50 percent on July 27.

Note: The takers are primarily money market funds. Banks collect interest on reserves greater than the reverse repo rate.

Unlimited Demand

There’s unlimited demand for free money and if the Fed offered more than $2.39.7 trillion in reverse repos there would have been unlimited takers.

It’s important to note this is a trivial amount of money compared to interest on reserves discussed below.

Q: Why is the Fed doing reverse repos?
A: The Fed is struggling to keep its target rate where it wants it.

Here’s the explanation on Repo and Reverse Repo Agreements straight out of the New York Fed’s mouth.

These open market operations support effective monetary policy implementation and smooth market functioning by helping maintain the federal funds (fed funds) rate within the FOMC’s target range.

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Q: Why is the Fed struggling to maintain the Fed Funds Rate in the target range?
A: The Fed forced so much cash down banks throat that banks are struggling for yield. Competition for short term assets drove down yields.

Proof of this is a 1-month T-Bill yielding only 1.33% with the Fed Funds rate at 1.50-1.75 percent with another big rate hike coming in less than a month.

Also note the current 3-month T-Bill rate is only 1.69%. Realistically, the 3-month T-Bill ought to reflect some portion of the rate hike coming up, but it doesn’t.

It’s important to understand that cash is a liability, not an asset of banks. The banks have to maintain capital positions on deposits. Banks seek to get rid of the cash that the Fed crammed down their throats.

Q: Why don’t banks lend this excess cash?
A: Banks do not lend from deposits. Except for QE, bank deposits are actually a result of lending. Loans create deposits, not the other way around.

Banks are struggling to get rid of this excess cash (that the Fed crammed down their throats), so much so that the Fed needs to conduct reverse repos or overnight rates would drop below the Fed’s target.

Q: Is this Reverse Repo system working?
A: The Fed says the “System is working as designed.”

I don’t doubt for a second the system is working as designed, but I do question the design and the Fed’s actions.

Keeping interest rates pegged near zero while conducting QE to the bitter end (March of 2022), was a major, major policy error.

Hooray, More Free Money

The Fed pays interest on all reserves. At the end of May, the total reserves were $3.318 trillion.

The Federal Reserve currently pays 1.65% interest on reserves IOR.

If the Fed hikes to the range of 2.25-2.50 percent as expected, then expect IOR to jump to 2.40%.

Q: On an annual basis, how much free money are we talking about?
A: 2.40 percent of $3.318 trillion is $79.63 billion!

Q: We are giving banks $79.63 billion in free money?
A: It’s a moving target.

The IOR keeps rising but the reserve balances keep declining.

That $79.63 billion reflects a hike that has not taken place yet. If the Fed keeps hiking at a pace that exceeds QT, then the amount will rise further. If not, the actual amount of free money will drop.

Q: Why does the Fed pay interest on reserves?
A: It has to, given the amount of money it shoved down banks’ throats. If it doesn’t, then note the NY Fed explanation: Repos and reverse repos help maintain the federal funds (fed funds) rate within the FOMC’s target range.

Q: Why doesn’t the Fed just drain all this QE instead of all these Mickey Mouse operations?
A: I do not have a good handle on that question, but I suspect the Fed fears consequences of a massive shock action they have never tried before. Meanwhile, please feel free to take comfort that the “system is functioning as designed”.

I have time for one final telepathic question. This question just came in.

Q: Why isn’t Elizabeth Warren screaming about nearly $80 billion in free money to banks?! What the hell?
A: The only rational explanation is that she does not know what’s going on.

I am surprised Warren has not picked up on this. But she will and so will AOC and all the Progressives.

And for a change, the Progressives will actually be moaning about a legitimate issue.

Expect a big stink over this because it’s coming.

The Fed will respond by bragging about refunding billions of dollars to the Treasury. But that’s an acute perversion of returning taxpayer money (interest on debt) without accounting for the free money siphoned off to banks.