With the massive issuance of US government bonds, money market funds have gradually invested excess funds into US government bonds, and the use of an important financial tool by the Federal Reserve has fallen below the $1 trillion mark for the first time since the end of the summer of 2021.
On Thursday, 94 counterparties (money market funds and other eligible companies) deposited a total of $993 billion in the Federal Reserve's overnight reverse repurchase agreement (RRP) facility. This is the first time since August 10, 2021 that the usage of overnight reverse repurchase tools has fallen below the $1 trillion mark.
After reaching a record high of $2.554 trillion on December 30, 2022, funds have been continuously flowing out of this mechanism in recent months.
The Federal Reserve's reverse repurchase tool is part of the Federal Reserve's interest rate control toolkit, aimed at providing a floor for short-term interest rates to ensure that Lianchuang maintains control over the federal funds rate, which is the Fed's main leverage in influencing economic direction. The current RRP interest rate is 5.3%, while the target range for federal funds is 5.25% to 5.5%.
Many market participants and central bankers have previously regarded the popularity of reverse repurchase tools as a sign of excess liquidity in the financial system.
When the Federal Reserve purchased a large number of bonds to provide stimulus during the COVID-19 epidemic, the inflow of the reverse repurchase mechanism expanded rapidly, rising sharply from almost zero in the spring of 2021.
Last year, the Federal Reserve began to shrink its balance sheet, allowing its holdings of nearly $100 billion in monthly bonds to expire without renewal, as part of the Federal Reserve's efforts to withdraw monetary easing policies. So far, the Federal Reserve has reduced the size of its bond investment portfolio by approximately $1 trillion.
Is Liquidity Starting to Tighten Under the Massive Issuance of Bonds?
In the first half of this year, the usage of overnight reverse repurchase tools by the Federal Reserve remained above $2 trillion per day. However, since June, the US Treasury Department has injected a large number of new notes into the market, encouraging funds to be transferred from the reverse repurchase instrument, because after Congress agreed to raise the US debt ceiling, the US government has been trying to fill the TGA account. As the funds in the TGA account continue to rise, the balance of the Federal Reserve's reverse repurchase has been gradually depleted.
The reason for the outflow of funds from reverse repurchase instruments is that companies can now invest in private securities with better returns, and the surge in Treasury bond issuance is attracting their attention from products provided by the central bank. The higher short-term bond yields increase the attractiveness of money market mutual funds to investors, especially when the interest rates of competitive products such as bank deposits fail to keep up with changes in interest rates.
Economists at JPMorgan Chase said on Thursday that, taking into account the issuance of treasury bond, the amount of reverse repo "should decline further".
Deutsche Bank strategist Steven Zeng also pointed out that "this is a significant change, as traders hold so many new bonds, the scale of the use of the Federal Reserve's overnight reverse repurchase agreement should further decrease
As the use of overnight reverse repurchase tools gradually decreases, Wall Street strategists are weighing whether this will have a further impact on the Federal Reserve's monetary policy, especially the process of deflation.
Some strategists say that if demand drops to zero, the Federal Reserve will have to stop its quantitative tightening plan (QT), as excess liquidity will be completely depleted and bank reserves will reach a scarcity level.
Some central bank governors and market participants have also tended to hold the view in the near future that when reverse repurchase tools are basically depleted, or at least much lower than now, the overall liquidity of the financial sector will be sufficiently tight, and the Federal Reserve can at least start considering slowing down the process of deflation, or even completely stopping it.
However, economists at JPMorgan Chase have stated that there is currently little possibility of an early end to the scale reduction process, which may continue until the end of 2024. They expect the level of reverse repurchase to still reach $700 billion by then.