An increase in reverse repurchase transactions could prompt the Fed to revise its current policy
A steady increase in the volume of reverse repo transactions by the Federal Reserve highlights the risks of the ultra-accommodative policy adopted by the US central bank, as the country’s financial institutions struggle to find places to park their reserves surplus.
The Federal Reserve’s decision to buy up to $ 120 billion per month in US Treasury bonds and Mortgage Backed Securities (MBS) to contain the financial fallout caused by the pandemic flooded the country’s financial system with liquidity and that liquidity flowed until it reached the banks in the form of higher deposits.
These higher reserves, combined with weak demand for loans, have resulted in the accumulation of large excess reserves, with financial institutions primarily allocating this money to fixed income securities, including treasury bills.
Even though the measure succeeded in containing the worst-case scenario for the bond market, it now seems to be backfiring as banks struggle to park their excess cash as they increasingly worry about the risks of holding large amounts of long-term bonds on their balance sheets, especially at some point. where inflation seems to be accelerating.
These concerns are reflected in the latest steady increase in the volume of reverse repo transactions carried out by the Federal Reserve Bank of New York – the branch of the US central bank responsible for conducting these transactions – as the data shows that the institution completed a $ 394.94 billion reverse repurchase transaction on May 25 – the largest one-day transaction reported by the branch since the late 2017s.
A reverse repurchase agreement – also known as a reverse repurchase agreement – is a transaction in which Bank A agrees to receive cash from Bank B, with Bank A pledging US Treasury securities as collateral for the transaction. Bank B is entitled to receive interest on this loan at a rate commonly known as the overnight rate.
For now, the Fed has managed to keep the overnight rate in positive territory by actively intervening in the repo market. They achieved this by acting as the institution that receives the money while paying the other party a minimum. interest rate going from 0% to 0.1%.
However, as excess reserves continue to accumulate, the risk that the Fed may not be able to fully satisfy the market’s appetite to park its reserves elsewhere could plunge repo rates into negative territory. This means that banks would start paying other institutions to conserve their liquidity.
If the situation comes to this, the big risk right now is that the Federal Reserve will be forced to hike rates much sooner than the market expects, in order to prevent repo rates from turning negative. .
“Right now, the more money you put in, you get it back immediately,” said Scott Skyrm, executive vice president of fixed income and repo at Curvature Securities at an interview with MarketWatch.
He added: “The market says ‘It’s time’. There is evidence that QE has gone too far, ”referring to the possibility that strong demand for reverse repo transactions from banks signals that the accommodative policy adopted by the US central bank has reached a point tipping.
How could this affect the financial markets?
The next Federal Open Market Committee (FOMC) meeting is scheduled for mid-June and it is likely that this could be an important topic of discussion.
Meanwhile, analysts who see this situation in the repo market as an indication that a policy change is due believe the Fed may begin to consider the idea of cutting back on short-term bond purchases.
Such a move could cause some temporary volatility in financial markets as it would signal a turning point in accommodative policies that have so far supported strained valuations in most asset classes.