Repurchase agreement (repo) and reverse repo

Introduction

A client recently asked why the reverse repo market has grown from zero in mid-March to $1 trillion at the end of July. In short, there is either too much cash or not enough collateral.  

Primary policy tool: FFR

The Federal Open Market Committee (FOMC) sets monetary policy by adjusting the Federal Funds Rate (FFR). In 2008, the FOMC went from a single rate to a target range for FFR. The FFR is the interest rate at which depository institutions and the Federal Home Loan Banks borrow and lend reserve balances to each other overnight. The official target is currently 0.00-0.25%. The Effective Fed Funds Rate (EFFR), the rate that clears the market, has recently averaged 0.08%.    

The FOMC has two other policy tools to ensure the FFR stays within the target range. The primary tool is Interest on Reserve Balances (IORB). Their secondary tool is Overnight Reverse Repurchase Agreements (ON RRP).     

Primary supplementary policy tool: IORB

On July 29, 2021, the Interest Rate on Excess Reserves (IOER) and the Interest Rate on Required Reserves (IORR) were replaced by IORB. Currently, reserve balances are slightly over $4 trillion. 

Secondary supplementary policy tool: ON RRP

A repurchase agreement (repo) is an overnight borrowing for dealers in government securities. A dealer sells government securities to investors in exchange for cash and buys them back the next day at a slightly higher price. The investor has entered a reverse repurchase agreement (reverse repo) with the dealer. They have agreed to buy securities and sell them back for a small gain. The reverse repo closes the repurchase contract. 

The ON RRP program began in 2013. There is typically activity at month and quarter-end. Since the end of March, use of the facility has exploded and recently topped $1 trillion. 

Total assets at the Federal Reserve (Fed) are $8.2 trillion, mostly U.S. Treasury securities. The Fed lends securities in exchange for cash and agrees to buy them back the next day. On Monday, Aug. 16, for example, 70 counterparties submitted $1.036 trillion in exchange for collateral at 0.05%. 

Not enough GSE collateral

Government-sponsored-entities (GSEs) include the Federal National Mortgage Association, known as Fannie Mae, (FNMA), Federal Home Loan Mortgage Corporation, known as Freddie Mac, (FHLMC), Federal Farm Credit Banks (FFCB) and Federal Home Loan Banks (FHLB). They were created by acts of Congress but not explicitly guaranteed by the government. 

For many reasons, GSE debt issuance is down substantially.  

What has changed?

• In March, the Fed raised the amount counterparties can lend to $80 billion from $30 billion
• In April, the Fed expanded the roster of ON RRP counterparties to include money-market funds 
• In mid-May, state and local governments received $100 billion of COVID-19 support payments
• In June, the Fed raised the rate on IORB to 0.15% from 0.10%  
• On July 31, the suspension of the debt ceiling expired. The Treasury’s cash balance had to be reduced to $450 billion, which was the balance when the ceiling was suspended. More cash entered the system  
• GSE collateral is scarce 

Conclusion

ON RRP eligible counterparties were expanded to include money-market funds on concerns they may “break the buck.” The amount counterparties can lend was increased by 166%. Homeowner mortgage payments provide additional cash every month. The Fed buys $120 billion in securities per month for its own account. “Quantitative easing” reduces available collateral and puts more cash in the system. Banks are not lending. The velocity of M2 money stock is falling.  We believe it is time for the Fed to taper. 

For more information, or to learn how Baker Tilly Investment Services can help your organization, contact our team.