May 19, 2021 5:55 PM ET
In this month’s PAM article on equity markets, we highlighted the primary risk to the financial markets at present as coming from the repo markets. This is what we said:
We wrote about the systemic liquidity tightening in the face of announced, sharp drawdowns in the Treasury General Account balance from what was $1.6 trillion early when we last wrote about it, to less than $500Billion by end of June 2021. We also said that most of these funds will flow to the newly enhanced Fed O/N RRP facility, the likely destination for these funds which need to find a home. And that is what happened.
The TGA drawdown was further exacerbated by the termination of the Supplementary Leverage Ratio (SLR) waivers ended at the end of March, the G-SIB large banks dis eschewed the trouble those deposits bring to their capital ratio calculations. Therefore, term money had to move out, and there aren’t many places to go. The RRP is the safest and less onerous place for these funds to go to, as zero pct rate at this Fed facility was a lot better than the negative term (money) market rates that is prevailing up to this time.
The problem is that TGA flows to RRP facility counteracts liquidity inflows, tightens systemic liquidity; reduces bank reserves, and pushes up volatility (VIX) which undercuts equities, and push long-term yields lower (see chart below).
Key take-aways from this chart:
The VIX is very sensitive to systemic liquidity, especially the Fed's Balance Sheet (e.g., Bank Reserves)..The take-ups at Fed's O/N Reverse Repo facility is building into a tsunami, which expunges Bank Reserve wholesale, after a lag.
There is empirical evidence that the effect of liquidity is transmitted to the SPX via the VIX, but the impact comes only after a long lag. This is the most insidious part – most investors can’t comprehend the long lags, so are oblivious to the approaching danger.
Simply put, RRP transactions reduce the stock of bank reserves. It is the change rate of bank reserves which power the rise and fall of financial asset prices -- which is why the drain towards the O/N RRP facility will hurt financial asset prices at some point. That point is fast approaching (see rectangle in chart above). That inflection point can come as early as the 3rd week of May, or during the last week of May.
These developments in the O/N Reverse Repo facility are not only a threat to the stock market, but it also threatens to upset the stability of the entire repo market – with possibly violent movements in the front-end, and in the ultra short-term rates.
It is now very clear that the financial system is increasing being unable to absorb and properly process the tsunami of new money from the Federal Reserve.
We, as well, earlier described genesis of this evolving situation in the PAM bond article in April 2021:The process of devolution from ultra-loose regime (in the front-end) to a tighter one is hastened by massive impounding of term (money) market liquidity at the Fed’s O/N Reverse Repo (RRP) facility (see chart above). At some point, the Fed may uncap the limits recently imposed on RRP counterparties to accommodate the flood of reserves created by, and emanating from, forever QE and forever fiscal stimulus.
The O/N RRP facility has also been sopping up the liquidity flowing out of the Treasury General Account (Treasury Cash Balance). The TGA has to be reduced to $500 Billion or less by end of June. TGA flows to RRP facility counteracts liquidity inflows, which tightens systemic liquidity. Funds flowing into the RPP facility reduces the quantity of reserve balances in the banking system, which undercuts equities, push long-term yields lower.
This is how the chart above looks now
Since we first noted the emerging situation, matters have become worse, and is probably heading into a more uncertain period, where the Fed may be forced once again to force on repo-market based “tantrum”.
The primary issue which is causing all these jitters – there are too many reserves being injected into the system, an extension of the Fed's relentless monetization of $120BN in debt each and every month.
As a result, front-end rates are going to zero, and term (money) markets are collapsing to negative rates. We just seen two 0.000% 4-week Bill auction, but overnight funding rates had collapsed with the fed funds rate well below the mid-point of the fed funds target range while the Repo GC rate is at zero; often trading negative.
As a result of these zero percent interest rates in bills, and negative rates in the money markets (MM), billions of dollars of cash were being pushed into the Fed's O/N RRP facility (which pays zero pct). That is a logical and fully anticipated consequence, as no rational investor would take on MM counterparty risk if they could get the exact same rate (0.0%) when transacting with the central bank. There are the other consequences: the Federal Reserve takes Treasuries out of the market through QE purchases, but then puts those Treasuries right back into the system via the O/N RRP when it accept the take-outs. The O/N RRP facility has never seen this high take-outs, outside of quarter-end turns, or during last year's COVID-19 disaster (see chart below).
Usage of the Fed's Reverse Repo facility has soared in recent weeks from zero to over $100 billion at the end of April, hitting a whopping $429 billion on May 12 (see chart above).
This a symptom and consequence of overnight rates being low; too low by all normal standards.The fed funds rate is well below the mid-point of the fed funds target range and the Repo GC rate is at zero; often trading negative.Zero percent interest rates in the MM are forcing billions of dollars of cash into the Fed's RRP facility. This cannot go on. Too much systemic liquidity is being impounded; too many bank reserves are being expunged.
There are more insidious issues which threaten to develop; the tsunami of cash going into the O/N RRP may transition into a bigger problem for the Fed. Curvature's CEO Scott Skyrm writes at the company blog that "now is a pretty good time to start talking about the size of the SOMA portfolio, even if some people don’t want to talk about it." Skyrm explains the linkage to a tapering of the SOMA portfolio, by reminding investors that even when the Fed starts tapering, the Fed balance sheet will continue to grow indefinitely, if at a slower pace, flooding the system with the same reserves that are now desperate to buy Bills at 0.000% or be parked at the Fed (for 0.000%).
As of last week, the SOMA portfolio stood at $7.185 trillion (see chart above) and the Fed continues purchases at $120 billion a month. If and when tapering starts, the purchases won't go from $120 billion to zero in one announcement. The purchases will gradually slow - going from $120 billion, to maybe $100 billion, to maybe $80 billion, to $50 billion, to $20 billion. By this math reckoning, Skyrm believes that another $900 billion could be added to the SOMA portfolio before the Fed is done tapering. That poses another set of problems on top of what the market is grappling with now.
Even today, there's barely enough collateral in the Repo market right now to cover all of the cash being invested. The O/N RRP shot up to $429 billion last week, removing sorely need collateral by that much from the market; what's going to happen when there's $900 billion fewer securities in the market by the middle of next year?
Conclusion:The capacity of the O/N RRP facility is, in theory, infinite. Money is stored and expunge with computer keystrokes – there are no physical money being exchanged by Banks and GSE’s taking out of the RRP. It is the impounding of Treasury securities in a big scale which may turn out to be the biggest problem of all in this brouhaha in the money markets. But the problems created in the process are enormous.
Aside from reduced collateral, bank reserves are being expunged, counteracting the market-friendly impact of the Fed’s QE. This has been happening for several months now, and the lagged effect will soon impact the markets negatively.
Moreover, at some point, US MM investors may opt to ship their capital abroad in FX-hedged transactions that will capture yield. That has tremendous repercussions for the US Dollar. If that happens, we expect the US domestic unit to fall sharply. At the same time, bond yields will tend to rise just as sharp, if a large part of the money flowing into the O/N RRP facility will go through that foreign route.
However, we expect the Fed to address the issue in due time by creating a permanent standing repo facility. The problem is that the Fed only acts on an issue when the markets dislocate. We expect the same sequence this time around. We expect the stock markets to fall and bond yields to fall before the Fed gets to addressing what essentially is a money market problem.