A wave of reverse repo operations could prompt the Fed to review its current policy

A steady increase in the volume of reverse repo transactions executed by the Federal Reserve is highlighting the risks of the US central bank’s ultra-accommodative policy as the country’s financial institutions struggle to find places to park their excess reserves.

The Federal Reserve’s decision to buy up to $ 120 billion a month in US Treasury Bills and Mortgage Backed Securities (MBS) to contain the financial fallout caused by the pandemic has flooded the country’s financial system with liquidity and that liquidity is been flowing down the drain until it reaches the banks in the form of higher deposits.

These increased reserves, combined with weak demand for loans, have led to the accumulation of vast excess reserves, with financial institutions mostly allocating that money in fixed income securities, including Treasury bills.

While the measure has been effective in containing the worst-case scenario for the bond market, it now appears to be backfiring as banks are struggling to park excess liquidity as they are increasingly concerned about the risks of holding large amounts of long-term securities. forward bonds on their balance sheets, especially at a time when inflation appears to be accelerating.

reverse repo operations

These concerns are reflected in the latest steady growth in the volume of reverse repo operations carried out by the Federal Reserve Bank of New York – the branch of the US central bank in charge of conducting these operations – as the data show that the institution executed a $ 394.94 billion reverse repo operation on May 25, the largest one-day transaction reported by the branch since late 2017.

A reverse repurchase agreement, also known as a reverse repo, is a transaction in which Bank A agrees to receive cash from Bank B, with Bank A pledging US Treasuries 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 ranging from 0% to 0.1%.

However, as excess reserves continue to accumulate, the risk that the Fed will not be able to fully satisfy the market’s appetite to park its reserves somewhere else could plunge repo rates into negative territory. This means that banks would start paying other institutions to hold their cash.

If the situation comes to this, the big risk at the moment is that the Federal Reserve may be forced to raise rates much sooner than the market expects as a way to prevent repo rates from turning negative.

“Right now, the more money you put in, you get it back right away,” said Scott Skyrm, executive vice president of fixed income and repo at Curvature Securities during an interview with MarketWatch.

He added: “The market is saying ‘it’s time’. There is evidence that QE has gone too far, ”referring to the possibility that the high demand for reverse repo transactions by banks is signaling that the accommodative policy adopted by the US central bank has reached a tipping point.

How could this affect the financial markets?

The next Federal Open Market Committee (FOMC) meeting is scheduled for mid-June and this is likely to be an important topic for discussion.

Meanwhile, analysts who see this situation in the repo market as an indication that a change in policy is due believe the Fed may start contemplating reducing its short-term bond purchases.

Such a move could cause temporary volatility in financial markets as it would mark a shift in the accommodative policies that have hitherto supported stretched valuations in most asset classes.

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