Reverse Repurchase Agreements are going through the roof and this publication goes straight to the point about what this is, what it means for the market as a whole and why this is important to your portfolio of assets. The chart below shows exactly how unprecedented this is and it is something to monitor.
Liquidity drives financial markets on a Macro scale.
If you’ve ever wondered how valuations can keep expanding up, it has directly to do with liquidity. In fact, it’s almost eery how in sync the Feds Balance Sheet and the S&P 500 are in sync but this is true.
There’s a few things that I want to make sure I pause and explain here. It’s important to know that asset expansion = quantitative easing. QE is when the fed buys treasuries (government debt) to expand economic activity and “inject” money into the financial system. In the case above, the blue line represents the feds balance sheet and the red line is the S&P 500. A few historical events to point out:
Back in 2014 you can see when tapering began the markets began to hiccup. In 2015, the markets essentially traded sideways and was a difficult year for investors. There were back to back market corrections/crashes that year. But, after awhile, the markets began to rally higher.
This resumed till 2018 when Fed policy began to become more hawkish. Essentially they announced the opposite of QE, quantitative tightening, and a series of interest rate hikes. What we began to witness was that the markets becoming increasingly volatile. Specifically, we witnessed at the back half of 2018 the markets began to sell off. Interestingly enough, the market bottomed when this came out, headline below: https://www.cnbc.com/2018/12/19/fed-hikes-rates-by-a-quarter-point-.html
The markets recovered but traded sideways till September/October, 2019 when the Fed announced it would resume asset purchases. Markets responded positively and began to rally.
This leads us to the COVID crash of 2020. Fed intervention and result goes without explanation with the unprecedented fiscal stimulus and asset purchases (refer to the fed balance sheet and S&P chart above) that essentially pulled us out of what could have been a depression. You can see a direct correlation with the Fed’s balance sheet expansion and the market rally we’re still experiencing now. Essentially, there are no coincidences here. But the brings us to the question, what in the world is going on with reverse repo’s and why are these important to pay attention to? Can they lead us to a crash/correction?
There’s a massive amount of liquidity in the system from QE
The Fed is currently creating $120B a month, this injection is an aggressive stance to heal and help the economy recover from the COVID crash. Remember, QE is the purchase of government debt. When treasuries are bought, interest rates go lower. When treasuries are sold off, interest rates go higher. Essentially, low interest rates = expensive bond prices and high interest rates = lower bond prices.
What QE has done is drastically lower not only the 10-year, or the 30-year. It has lowered short term treasuries as well. You can see on the 1-month treasury rate.
With rates this low and QE likely to continue going, this has created a big risk of negative rates without any Fed intervention. This drastically endangers the money market industry (funds that make money on short term, low risk investments). If money market funds are not able to be profitable this could endanger the broader financial system. The Fed’s solution to potentially short dated interest rates are reverse repo’s.
Reverse repo’s are when an institution purchases, in this instance, federal treasury bills for a short dated period of time and collects interest on that T-Bill and then sells it back to the fed. Typically this happens over night. The Fed has used this mechanism by increasing the reverse repo rate from 0% to .05%, which has led to preventing institutions from buying short dated bonds that would most likely create negative interest rates. In addition to increasing the rate, they expanded how much an institution can agree upon and how many different institutions can do this.
To simplify this, the fed has used reverse repo’s as a way to prevent negative interest rates on short dated bonds to protect the money market industry because there is too much liquidity in the system.
This risks of this and what to be careful of
Reverse repo’s also suck liquidity from the financial markets as a whole, temporarily or permanently. This ties directly back with my first point that liquidity drives the markets. Essentially, in my opinion, I am drawing two conclusions from this.
This huge title wave of liquidity floating in the system can lead to a different result when the Fed announces tapering this time around. Reverse repo’s and bond prices being historically low, this leads us to believe that there’s trillions of dollars out there with no where to go. The Fed is also unlikely to abruptly taper or announce tapering till their “goals are reached” which means more liquidity sloshing in the system. Basically, we could see a taper tantrum but stock prices can continue to go higher in any major sell off due to cash standing on the sidelines.
With this syphoning of money through reverse repo’s in the financial system, this can actually lead to a further decrease in liquidity available for the broader markets as a whole if short term assets are not converted into long term assets. This can position us in some volatile times if reverse repo’s become completely out of control and can begin to compete with bonds and stocks for much desired yield.
Conclusion
The reverse repo’s are unlikely to lead to a broad market sell off or crash, but if not monitored carefully and when it’s noticeable this becomes out of control this can suck liquidity from the financial system which can create volatile stock prices.
Hope you guys liked this macro analysis. As always, stay tuned, and stay classy.
Dillon
*Disclaimer* I am not a certified financial advice and this article is based on my own personal research and is my opinion. This is not designed to make financial decisions, always do your own research and draw your own conclusions.