Few people are familiar with the repo market in the U.S., even though it plays a crucial role in the world financial system. Something strange is going on here again.
The following chart shows the volume of the Fed’s so-called reverse repo transactions with a one-day duration. In these transactions, banks and money market funds, for example, can park excess liquidity that they do not currently need with the Fed. Apparently, banks and money market funds in the U.S. are currently swimming in more liquidity than they are comfortable with. This at least explains why the volume of daily reverse repo trades with the Fed climbed to a new record high (since the trades were introduced in 2013) of $485 billion last Thursday.
Banks and other players in the repo market are currently parking more money than ever before with the Fed
The sudden explosion in demand for reverse repo transactions is also strange because the Fed is currently paying no interest on the money parked with it under the repo facility. So banks and money market funds simply do not seem to see any way to invest their funds at more than zero interest rates in the short term. This is because, although interest rates in the long-term sector have risen sharply since the beginning of the year in the face of inflation concerns, they have recently fallen significantly in one-day repo transactions and are even threatening to slip into negative territory.
In recent years, there has been repeated turbulence in the repo market
In September 2019 and around the turn of the year 2019/2020, liquidity on the repo market threatened to dry up. Short-term interest rates suddenly skyrocketed and the Federal Reserve nearly lost control of the market as players in the repo market only wanted to lend money to each other at high interest rates. The Fed responded with repo transactions in the three- to four-digit billion dollar range, pumping more money into the market than ever before.
Meanwhile, the repo market is plagued by the opposite problems
There is simply too much liquidity in the system and the banks don’t know what to do with all the money. The main reason for the high liquidity is the measures taken by the U.S. Federal Reserve to combat the Corona pandemic. As a result, it has triggered a flood of liquidity on the repo market, which is now having its full effect.
For the stock market, the current situation on the repo market could be relevant above all because it could force the Fed to reduce its quantitative easing program soon. That’s because the Fed is still pumping $120 billion a month into the market via purchases of government bonds and mortgage securities. But the banks obviously can’t do anything with all that money anymore.
The Fed is also causing problems through its purchases: At the same rate that money is being pumped into the market through the purchases, the Fed is taking out of the market government bonds and mortgage securities that banks need as collateral when they borrow money in the repo market, for example. Through reverse repurchase agreements, the Fed returns this collateral to the market, but only ever temporarily.
If the Fed does not scale back its bond purchases in the coming months, it will create an ever greater imbalance between (too much) cash and (too little) collateral in the repo market, which could pose greater problems for banks.