The reduction in liquidity in global markets has already begun, with hundreds of billions of reserves leaving the system. But this reduction may not only fail to curb risk assets, but may also lead to a tightening of hidden markets, allowing the Fed to implement loose policies again without turning, and here the liquidity of the repo market will play an important role.

Recently, we have witnessed the effects of “temporary policy”, where the Fed’s silence and inaction on tightening policy caused the financial machine to drive risk assets soaring. “TGA Supplement” failed to end the most nasty rally in history - the market needs more tightening.

The US government is replenishing its bank accounts (TGA) to pay its bills while reducing the Fed’s balance sheet through QT (quantitative tightening). If the subsequent reduction in reserves is too severe, the Fed may encounter an unexpected surprise in the most critical funding market…

The repo market is the lubricant of the financial engine of the US empire. Without it, dollar liquidity would be dull. Tying together the Treasury cash and futures markets through carry trades such as the futures basis is just one of its many functions.

But most importantly, the repo market enables “secured” dollar lending to flourish around the world. It looks complicated, but it’s really just a market that matches lenders of cash (like money funds that have to invest in plain dollars) with borrowers of cash (like hedge funds that have to fund leveraged positions).

When Conk’s Repo Conga was revealed, everything became clear. The repo market is a chain of market participants who want to profit by charging a spread over the cost of funding. Cash lenders provide loans to “complex” borrowers through dealers, who charge a spread for intermediation.

In a classic conga dance, money market funds (MMFs) lend to primary dealers at the Fed, who then lend to smaller securities dealers, who then lend to leveraged investors like hedge funds. The goal of the repo market is to provide a constant flow of liquidity, and it succeeds in spectacular fashion.

The repo market consists of multiple segments, each of which plays a distinct role in providing liquidity. At the top, tri-party repo allows cash lenders (primarily asset managers such as MMFs) to lend primarily to the Fed’s primary dealers, who are tasked with allocating cash to other segments of the repo market.

The major dealers then try to profit by lending these funds in the “dealer-to-dealer” market and charging a higher spread. Smaller securities dealers will lend the cash to customers in the “dealer-to-customer” market, charging a higher fee…

At least, that’s how the repo market is supposed to work. However, in recent events, the increased complexity of the market, and even excess liquidity, have become problematic. But ironically, this will provide leaders with a concrete “non-QE” tool to stimulate the market, namely “repo market redemptions.”

In September 2019, the “repocalypse” came to our attention. Money market rates and even the Fed Funds rate (the Fed’s key policy rate) surged above the target range. The Fed’s response marked the beginning of a shift from an “excess collateral” to an “excess cash” regime.

After trying to reduce its balance sheet with the first official QT (quantitative tightening), the Fed executed a 180-degree turn and restarted QE (quantitative easing), injecting reserves into the banking system to bring interest rates back into range, and from then on the cash flood had begun.

Then, just months after the “repo market crisis” and the subsequent round of QE, the COVID-19 market panic hit. Amid unprecedented uncertainty, the Fed injected massive reserves to stem the illiquidity in every key market, from FX swaps to Eurodollars.

The Fed’s monetary policy eventually eased the financial panic, but QE continued. By 2021, reserves had become more plentiful. However, the cash flood did not stop at the US central bank, and by the end of 2021, the US government had accumulated a record balance in its checking account, the TGA (Treasury General Account), after a sharp increase in expected benefits. When the government sent funds in the TGA to the banking system, this unlocked more liquidity.

“Neutralized reserves,” cash balances that could not be invested in the economy or financial assets, were converted into liquidity reserves and entered the banking system, prompting banks to create deposits to balance their books. The “cash flood” reached ridiculous proportions, and even before then, just after the COVID market panic reached its maximum, the cash surplus was so severe that regulators were forced to allow banks to bypass regulatory limits on the size of their balance sheets.

In April 2020, regulators exempted U.S. Treasuries and bank reserves from the SLR (supplementary leverage ratio), a rule that limits the amount of leverage certain financial institutions can achieve. As a result, Wall Street absorbed the excess funds. The cash flood was hampered.

At least, temporarily. More than a year after the COVID market panic subsided, during the most significant monetary mania in human history, the SLR exemption expired, causing banks to sell off hundreds of billions of (now "excess") reserves. This money had to go somewhere, and after considering all options, banks began to reduce deposits by removing the incentive for customers to deposit money, i.e. charging negative deposit rates and refusing new funds. The next best place for this excess cash was the Fed's reverse repo operations).

After leverage restrictions were reinstated in April 2021, investors evaluated risk/reward and regulations. Money then poured into RRPs as investors saw MMFs as the best investment. Cash lenders prefer safety of funds and liquidity over returns. Money funds were ideal, so trillions of fiscal stimulus ended up flowing into the Fed’s RRPs. The main financial plumbing – the big banks and primary dealers – had been blocked. So the “cash flood” was channeled into MMFs, which invested heavily in the Fed’s reverse repo operations.

Now, the Fed’s RRP has become a benchmark for measuring the balance between excess cash and collateral in the system. If global financial giants direct funds to RRP, cash is likely to be abundant. Unless the RRP balance drops to zero, there is still too much money in the system.

In fact, cash is so abundant that some repo rates are already below the Fed’s RRP, the risk-free rate in the repo market. A series of QE, government spending, and regulation have broken the Fed’s floor. Even the Fed-managed rates (TGCR/BGCR) are now below the RRP rate.

Since only certain entities can use RRP (i.e., primary dealers, government-sponsored enterprises like Fannie Mae, and most major money market funds), all others must accept lower interest rates and lend at deep discounts to already well-funded dealers.

Unless the trillions in excess cash somehow disappear (signaling the end of the “excess cash” era), the Fed’s RRP facility usage will remain elevated, with some repo rates falling below risk-free territory. Liquidity will remain ample, and a repeat of 2019 is doubtful.

But this too may change, as the era of trying to return to “excess collateral” has begun. QT and “TGA replenishment” will remove bank reserves from the system. Furthermore, a spike in repo rates is only possible due to the intrinsic nature of the repo market. However, today, with RRPs full of cash, this is unlikely to happen.

If interest rates start to spike like they did in 2019, the trillions of dollars in the RRP will serve as the penultimate line of defense against a “repo market crisis.” Cash lenders will withdraw cash from the RRP for a higher yield. If they refuse, the Fed’s SRF will serve as a lender of last resort, i.e. “non-QE.”

Unlike the response to the 2019 repo market crisis, trading in the repo market is expected to be seen as stimulative without the Fed having to restart QE. It will be another tool to boost risk sentiment while again avoiding