Reverse Repo (RRP) isn’t what they say it is. I’ve found misinformation in The Wall Street Journal, NASDAQ’s own website, and just about every YouTube video I’ve attempted to watch. So let’s set some things straight: it’s not a bailout (except for maybe the Fed in terms of inflation if they’re lucky), it’s not a cheat, it’s not for hedge funds, but it is a dangerous game the Fed is playing. Additionally, the facility participants consist of ~90% money market mutual funds while banks themselves have not used the RRP facility (as best I can tell, at least not yet). It works by the Fed loaning or selling securities on the Fed’s balance sheet along with an interest payment in exchange for cash from the participant with the Fed buying back the securities the next day to repeat the exercise. This removes liquidity from the system, further assisting in QT by forming an interest rate floor enforced by interest the Fed pays the participant. This rate just increased with the federal funds rate yesterday to 1.55%.
The thesis here is that as the Fed raises rates and conducts Quantitative Tightening (QT) the RRP facility will continue to grow in size as investors leave stocks and bonds for the safety of the Fed’s facility through their money market funds that they will soon start noticing (in even greater numbers) are paying a decent interest rate. This growth could further accelerate with market volatility as the Fed is forced to continue to raise rates for both the fed funds rate and the RRP facility in tandem to maintain an interest rate floor (a means to hold interest rates up artificially). While the RRP facility grows, QT will cause the Fed’s System Open Market Account (SOMA) to shrink from its current size of $8.4T. This account holds the loanable Treasuries (and potentially loanable agency MBSs?) needed for the RRP facility to work and number $4.9T. This constitutes the current total limit of the loan power of the facility. However, the theoretical hard limit of the size of the RRP facility is constrained by the amount of securities the Fed holds (that are loanable). In any case, the shrinking SOMA is on a collision course with the quickly increasing balance of the RRP facility.
The FOMC directed the Desk to undertake overnight RRP (ON RRP) operations in amounts limited only by the value of Treasury securities held outright in the SOMA that are available for such operations.
If the size of the RRP facility were to increase to the level of the balance of loanable SOMA securities (whether that ultimately only Treasuries or the entire SOMA), the Fed would have few good options and would likely lose control of interest rates potentially causing inflation to rage out of control or persist at high levels above the 2% target as rates would be forced down by the excess cash rushing to a limited number of bonds outside of the facility. Very bad.
Over the last 10 or so days, the facility has grown in total size by ~$20B/day and since the beginning of initial ramp up last year ~$10B/day. If the facility were just to maintain the $20B/day rate given the increased incentive due to higher rates in the facility looking forward, the RRP daily balance could exceed $4T by the fall which would be nearly the amount of Treasuries held at that time assuming QT continues.
Of course, the Fed cannot even allow this to become a nightly news topic of discussion so you can expect the Fed to act more and more aggressively until they’ve killed inflation especially if the RRP facility daily balance continues to grow as it has. They’ll likely do whatever it takes to accomplish this by the fall or end of year at very latest when the Fed could realistically be down to $2.5T in total reserves in the conservative case and very little in Treasuries (which would likely have already compelled the Fed to change the rules from Treasuries only if that’s possible). I believe this was the reason for the 75bp hike, why J Pow was willing to put his credibility at further risk. There really wasn’t an alternative here.
My fear, however, is that the necessary increases in RRP rates to support the rate floor will cause additional market volatility and resulting downward pressure that could push more and more cash into money market funds and ultimately into the RRP facility. This sort of potential feedback loop could lead to a liquidity crisis that cannot be immediately stopped even without a loss of interest rate floor.
I made the below video expanding on the above topics. I tried to make everything so it would be clear to as many of you as possible.
I believe the math here means at very least that we get to where we’re going, wherever that may be, more quickly than many here or in the market are thinking and I believe a recession is almost 100% certain.
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