One of the classic bullish arguments is that there is plenty of cash on the sidelines. Sometimes it seems that the phrase is invoked reflexively by optimistic analysts, other times it is backed up with statistics like the percentage of cash held by mutual funds. One source of cash on the sidelines may in fact be right under our noses at the New York Fed – its reverse repo facility. Consider the following chart:
Yesterday we set a record high of $2.091 trillion after seeing the values rising at a fairly steady pace over the past year. There were spikes at the end of each of the prior quarters – it is normal to see banks utilize the repo and reverse repo facilities to help manage their balance sheets at quarterly reporting times – but we have since surpassed what was then the record spike at year end. For a sense of how unprecedented this activity is, here is the full data series available on the New York Fed’s site:
It is important to remember what a reverse repo (RRP) is and what is attempting to achieve. The New York Fed defines it this way:
A reverse repurchase agreement conducted by the Desk, also called a “reverse repo” or “RRP,” is a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the transaction.
When the bank or other counterparty buys a security from the Fed, the cash is moved from the bank to the Fed. That makes RRP a method for the Fed to temporarily absorb excess liquidity in the banking system. By setting a rate just above the low end of the Fed’s target, the Fed can prevent short-term rates from sinking below the level it desires. This became an important mechanism in the first half of 2021. The Fed Funds target was 0-0.25%, and excess liquidity was threatening to take interest rates into negative territory. By accepting RRP at 5 basis points, the counterparties were able to receive a positive rate of return on their cash, no matter how meager. Yet rates rose, so has usage of the RRP facility, so there are clearly other factors at work.
With the prospect of rising rates, many holders of risk assets have been selling them and raising cash. That’s why most of them have been trading lower. That cash now sits in bank balances and money market accounts. Meanwhile, the Fed had continued to increase its balance sheet – it only peaked an plateaued about two months ago — largely by purchasing government and mortgage securities, as shown by the graph below:
I have described this as filling a pool at one end and draining it at the other. In effect, the Fed was competing with its counterparties for low-risk assets. We finally see that the Fed turned off the hose and will begin to shrink its balance sheet (aka “quantitative tightening”, or “QT”) by letting bonds on its balance sheet mature (that is widely assumed to begin in a week). The problem is that the pace of QT will be $47.5 billion for the first three months, then $95 billion thereafter. Some simple arithmetic implies that it would take quite a while for that amount to make a significant dent in the $2 trillion RRP.
The bad news is this: the Fed will need to be relentless if it is serious about reducing the amount of excess liquidity in the system. The good news is this: it is not at all clear that the Fed is currently willing to undertake those measures; until they do, this could provide a source of support for risk assets when they come under pressure. There appears to be plenty of cash on the sidelines – it depends upon investors’ willingness to deploy it.
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