Reverse Repo Is The Spookiest 1.6 TRILLION Dollar Market You've Never Heard Of - And The Legal Limit Just DOUBLED
The market is a house of cards. And the house is made out of cash.
It’s October, so it only felt right to write about something spookier than Michael Meyers. Anyway…
Take a look at this chart and make an observation. What stands out?
If you’re like me, you said something like “that line seems to be going up a lot more than it ever has before.” That’s nothing new in the current climate of everything being “unprecedented,” but this truly is unprecedented.
This is a chart of the Federal Reserve’s Overnight Reverse Repurchase Agreements, otherwise known as the Reverse Repo Market.
Here’s a few technical sentences to outline what this is - And if none of this makes sense, keep reading. I’ll explain it simply.
First, Treasury Bonds (something you’ll see a lot of in this article) are released by the US Government so they can raise money for day-to-day spending or major projects. These are long-term investments that can last anywhere between 10 and 30 years. They pay a small return and are seen as some of the safest investments anyone can make, given that the US has never defaulted on debt.
Now, let’s understand what a repo transaction is before we get to the whole reverse part.
In a repo transaction, the Fed purchases Treasury, agency debt, or agency mortgage-backed securities (MBS) from a counterparty subject to an agreement to resell the securities at a later date. It is economically similar to a loan collateralized by securities having a value higher than the loan to protect the Fed against market and credit risk. Repo transactions temporarily increase the quantity of reserve balances in the banking system.
The Repo Market is a short term asset swap borrowing program (typically overnight), that allows global trade to exist. The US Dollar is the world reserve currency, so the world needs those US Dollars to conduct business.
In simple terms, whoever needs cash posts collateral to get the cash they need.
Ok now let’s reverse that, first with the whole 9 yards, then simply explained.
In a reverse repo transaction, the opposite occurs: the Fed sells securities to a counterparty subject to an agreement to repurchase the securities at a later date at a higher repurchase price. Reverse repo transactions temporarily reduce the quantity of reserve balances in the banking system.
Reverse Repo is a liability swap (as opposed to an asset swap).
What is a liability to a bank? Cash.
To you and me, cash is an asset. But not to the banks.
Cash that isn’t working for the banks as a part of fractional reserve lending (by getting loaned out and generating more cash) is cash that isn’t making money for them, therefore it’s a liability because they still have to pay you the interest you’re owed in your savings account (if you have one, I don’t - More on this soon).
In simpler terms, in a Reverse Repo banks have a lot of cash. They want to get rid of it (temporarily) and maybe even make a little bit of money on it.
Ok, I understand the terminology. What is going on?
To understand this, let’s first start with the little spike in mid March 2020, right about when COVID was hitting the news and the country panicked. Putting the same chart from above here so you don’t have to scroll up to see what I’m talking about.
Why did it spike then? Businesses decided to lay people off, cut spending, and stockpile as much cash as they could to insulate themselves from whatever was about to come.
Here we are about a year and a half later and oh my goodness the Federal Reserve has printed more money than you and I can fathom. That’s a part of what resulted in this blue line flying upward (but didn’t directly create it - important distinction).
This chart is really showing banks and other institutions borrowing treasury bonds overnight in exchange for giving the Federal Reserve their cash overnight.
Keeping Rates Down…
When banks and institutions participate in the Reverse Repo Market (RR from here on out) they get those treasury bonds overnight.
If the banks are holding those treasury bonds, then the Fed of course cannot go sell the bonds on the open market. This reduces the supply of available treasury bonds.
When supply of treasury bonds decreases, price increases. When price increases, rates decrease.
Simple supply and demand economics require this. Rates decrease on bonds when price increases. Think of a seesaw. Rates go up, prices go down. And vice versa.
But get this. The Fed is already buying $80 billion worth of Treasury Bonds themselves every month.
Whoa, Give Me A Recap?
The Fed is printing crazy amounts of money
The Fed is buying $80,000,000,000 dollars worth of Treasury Bonds every month
This increases the price of the bonds (high demand, lowers supply)
When bond price increases, yield (interest rate) decreases
Ok now add this to the mix…
Banks have so much cash they don’t know what to do with it (thanks to the Fed printing so much from above…)
Banks are participating in the RR market, swapping cash for Treasury Bonds overnight, further reducing the supply of Treasury Bonds
This increases the price of the bonds (high demand, lowers supply)
When bond price increases, yield (interest rate) decreases
You’ll notice that steps 3 and 4 are the same.
The Fed wants to keep rates as low as possible to encourage borrowing by businesses, in the hope that these businesses will then take that money and go invest it in the economy by hiring workers, purchasing materials, etc. Low rates are also important for the people because they keep mortgage rates low, car loans low, etc.
Again, the goal is to encourage purchasing and investment because our economic model is built on continuous growth. High rates would crush growth and send us into a recession.
This is all of course done on purpose by the Fed because it creates a positive feedback loop (otherwise known as a snowball rolling downhill). More creates more (cash), which creates more (again, cash), and so on. At a high level, this makes sense and sounds like good policy.
But There’s A Major Problem…
Nobody is borrowing. This line is going the wrong way, as far as the Fed is concerned.
The Government and the Fed know this spells trouble, so on September 9th, they expanded the maximum small business loan through the COVID Economic Injury Disaster Loan Program amount to $2 million dollars. A 300% increase! Hoping that this will get people to borrow and invest more money…
An act of desperation.
Our Economy Is A House Of Cards (Built On Cash)
The house of cards topic might warrant it’s own newsletter soon, but I’ll say this for now.
Our economy is being propped up by the Fed. Their post COVID policies were designed to avoid a massive crash, and they did just that.
By pulling out all the stops to keep interest rates low, the Fed is trying with everything they have to create real strength from artificial money.
What do I mean by that? The money they’ve created out of thin air can only go so far.
The idea is this - Businesses need to hire people, build infrastructure, put people to work, and inflation will fall as a result. They’re trying to make this as attractive as possible by keeping rates low. Hoping that unemployment will fall and we’ll come flying out of this stronger than ever! Woo!
The flip side here is that by allowing all of these banks to participate in the RR market, they’re creating more inflation. Which if you read my last article, the Fed doesn’t think is a problem (“its transitory”). I completely disagree.
But the problem with their master plan is this - Businesses already have enough money. They have so much money that they don’t know what to do with it, so they’re giving it back to the Fed overnight to help artificially keep interest rates as low as possible.
In other words, the Fed is digging a pond in the hopes that the people with their own personal lakes come swim in it. Seems unlikely.
You Promised To Talk About A Spooky $1.6 Trillion Dollar Market?
Correct. I did. And if you consider breaking records spooky, this is the spookiest of them all.
This article will be published on October 4th, 2021. The most recent data I have for the RR market is at the last market close, which was October 1st, 2021. However, the day I want to talk about was the one before that, 9/30/2021.
Overnight on September 30th, 2021, the Reverse Repo market hit a record high of $1,604,880,000,000 with a record 92 participants.
That means that banks and other institutions had $1.6 trillion dollars of money they don’t know what to do with. They gave it to the Fed overnight for 0.05% interest, in exchange for treasury bonds, just like we discussed earlier.
And here’s what that looks like. The top chart is the same one at the start of this article, showing the RR market flying skyward. The bottom chart is showing how the average amount each party is contributing has also skyrocketed. Makes sense.
Numbers time.
$1,604,880,000,000 with 92 participants means that the average was about $17.44 billion each contributed. But averages can be skewed.
For example, if you take the increase of my net worth and Jeff Bezos’s net worth over the last year and average them, it looks like I’ve gotten $40 billion dollars richer this year!
Sadly, I have not, and that’s why averages are deceptive. More on this in a moment.
The FOMC Doubled The Maximum Reverse Repo Limit!
On 9/22/2021, the FOMC (Federal Open Market Committee) doubled the amount of money each participant can use in the Reverse Repo market. And the numbers are crazy. (Link to press release).
The previous limit was $80 billion dollars. The new limit is $160 billion dollars.
The average amount of money per participant in the RR market was $17.44 billion dollars… But they raised the limit…
So what does this mean, and why did they do it?
Just like when you compare me to Jeff Bezos, the average of our wealth is wildly misleading. Same thing here.
My takeaway is that there’s at least one participant in the Reverse Repo market that was getting dangerously close to that $80 billion dollar limit, so they raised the cap.
Here’s the spookiest part. We went into 2021 with a cap of $30 billion. That cap hadn’t been raised since 2014. Now in the space of one year, the cap has been raised twice, jumping a total of 433%. What could go wrong here…
I See Big Numbers, But What Does It All Mean?
In a word, trouble.
The reason the banks and institutions are parking all their cash in the RR market is because they don’t know where else to put it. When the RR market spikes, it is indicative of a complete lack of faith in the markets as a whole.
The banks and institutions would rather get 0.05% interest overnight guaranteed than invest it literally anywhere else.
I think many of you will agree that a market correction or crash is inevitable at some point. This is making sure that crash is going to hurt worse than anything you’ve ever seen before.
Coming out of COVID, our economy fundamentally changed. A crash/correction or at least a reallocation of labor and supply had to happen, and that takes time.
Instead, the Fed tried to print their way out of a recession without allowing the market to properly readjust.
The Fed tried to put a golden bandaid over a wound requiring surgery. The surgery is inevitable, it’s just going to hurt a lot more when we finally get there.
Thank you for reading today’s article, if you enjoyed or learned something, please consider subscribing to the Decentralized Way (it’s free!) Or find me on Twitter @decentralizedJ