The RRP mechanism (Reverse Repurchase Agreement) has become an important short-term liquidity adjustment tool of the Federal Reserve in the past decade. The specific operation is that the Federal Reserve sells securities to financial institutions and promises to repurchase these securities at a predetermined price at a certain time in the future. Simply put, the Federal Reserve "borrows" cash from financial institutions with U.S. Treasury bonds as collateral and pays a certain interest. After a period of time (usually overnight, that is, one day), the money is returned. This interest rate is 20 basis points lower than the upper limit of the Federal Reserve's target interest rate. Currently, the interest rate cap is 5.5%, so the RRP interest rate is 5.3%.
The most direct effect of this mechanism is to drain excess funds from the financial system. When funds are deposited with the Federal Reserve, they cannot be used or re-pledged, thereby reducing the liquidity of the financial system. When the agreement expires, the Federal Reserve repurchases securities, and these funds re-enter the market, increasing liquidity, which is very flexible.
RRP origin
The origin of RRP can be traced back to the early operations of the Federal Reserve. As early as the 1980s, the Federal Reserve used similar repurchase agreements (Repo) and reverse repurchase agreements (RRP) to manage short-term interest rates and market liquidity. However, these operations were relatively small at the time and did not become conventional tools. After the global financial crisis in 2008, the Federal Reserve implemented a series of unconventional monetary policies, such as quantitative easing (QE), which led to the accumulation of a large amount of excess reserves in the banking system.
Traditionally, the Fed influences the cost of borrowing between banks by adjusting the federal funds rate and the overnight interbank lending rate. However, after a large-scale liquidity injection, banks generally no longer need to borrow from each other to meet their daily funding needs, which leads to a decrease in trading volume in the federal funds market and the federal funds rate becoming unstable or close to zero, even though the Fed wants to keep it within the target range. In this case, the traditional way of influencing the federal funds rate by adjusting interbank liquidity fails because banks no longer need to look for funds in the market. Simply put, banks have sufficient excess reserves, which weakens the effectiveness of the federal funds rate as a major monetary policy tool. (This is also the underlying reason why I have always said that the United States has become desensitized to interest rates. It has taken too many drugs to flood the market with money. The difference between interest rates is only zero and non-zero, and ordinary interest rate cuts are actually very slow to take effect)
Therefore, the Federal Reserve needs to introduce new interest rate and liquidity control tools, among which the reverse repurchase agreement (RRP) is an important tool officially launched in 2013. Through RRP, the Federal Reserve provides short-term risk-free investment returns, which can effectively affect the bottom range of short-term interest rates, absorb excess liquidity in the market, and prevent excessive declines in market interest rates.
Main Participants of RRP
It should be noted that the initial service objects of RRP include large banks, money market funds, securities dealers, etc. However, banks do not usually use RRP because the Federal Reserve also has an excess reserve interest rate system (IOR) to pay interest on banks' excess reserves. The interest rate of IOR is set at 10 basis points lower than the upper limit of the target federal funds rate, that is, 5.4%. Therefore, when the IOR is 5.4%, it makes no sense for banks to use RRP at 5.3%. Today, about 5% of the participation in RRP comes from some banks, and the remaining 95% comes from major money market funds. Money market funds are similar to Yu'ebao in China. They attract personal savings by promoting high annualized interest rates and invest these funds in RRP or short-term treasury bonds to earn interest rate spreads.
As shown in the figure, the RRP balance was less than $2 billion in 2020. As the Fed implemented unlimited QE and liquidity overflowed, RRP became a temporary reservoir. In January 2023, the RRP balance reached a peak of $2.5 trillion for the first time, and gradually released liquidity to the market over the next year or so. Last week, RRP fell below $300 billion for the first time since 2021.
So, what is the reason for the decline of RRP since the middle of 2023? In the past few months, the account balance has been fluctuating within a range, but why did it suddenly fall below 300 billion last week? Before answering this question, we need to briefly introduce the working principle of money market funds.
How does the interest rate affect the RRP balance?
The portfolio of a money market fund is not entirely made up of RRPs, although RRPs have relatively high interest rates and are risk-free assets. Money market funds usually invest in a variety of short-term debt instruments, such as U.S. Treasury bonds, commercial paper, and bank certificates of deposit (CDs), to find the best balance between risk and return. The maturity of these instruments is usually within one year, and many are even less than one month.
As we all know, bond prices are inversely related to market interest rates. When market interest rates rise, bond prices generally fall, and vice versa. The key is that interest rate changes will have a greater impact on the prices of longer-term bonds than on shorter-term bonds, because short-term bonds have a shorter maturity period, and as the maturity date approaches, their prices tend to be closer to the par value, thus reducing the impact of market interest rate changes on their prices. For example, if interest rates are expected to rise, although all bond prices will fall, the prices of long-term bonds will fall faster, so it is wise to reduce the holdings of long-term bonds and increase the allocation of short-term debt.
More accurately, this strategy should be referred to as controlling the weighted average maturity (WAM) of the portfolio, which is a measure of duration risk. For example:
· Suppose a money market fund invests in the following instruments: o $2 million in US Treasuries with a maturity of 90 days o $3 million in commercial paper with a maturity of 45 days · Then the WAM is (200*90) + (300*45) / (200+300) = 63 days. The Fed starts raising interest rates in March 2022 and continues until mid-2023. During this period, money market fund managers believe that short-term interest rates will continue to rise, so they will shorten the term as much as possible. RRP is the best "short-term bond" in the eyes of money market funds. The current interest rate is 5.30%, the term is one day (overnight), and the counterparty is the ultra-safe Federal Reserve Bank. It is logical that when the Fed raises interest rates, money market funds will flock to RRP and "roll" it every day. This is indeed the case. During this period, the balance of RRP climbed to $2.5 trillion, accounting for about 50% of the money market fund portfolio at its peak. However, when the Fed stops raising interest rates in July 2023, the timing of the first rate cut becomes the focus. Money market funds are beginning to consider extending the average maturity of their portfolios and reducing their allocation to RRPs. The reason is that when fund managers expect interest rates to fall, the price of long-term bonds will rise faster, so they should reduce their holdings of short-term bonds and allocate long-term bonds. Of course, the purpose of doing this is not to appreciate the value of bonds, but to control book risk. The case of Silicon Valley Bank's bankruptcy due to bond maturity mismatch is a warning. In addition, buying long-term bonds can lock in the current high interest rate for as long as possible, which gives these funds a few more months to promote higher yields to attract funds. In short, as a high-quality short-term asset, the demand for RRP is largely based on the prediction of interest rate changes by money market fund managers. Then, it is easy to explain why the balance of RRP fell below 300 billion last week. Recent inflation and unemployment data have led the market to generally expect that the Federal Reserve will start to cut interest rates in September. Fund managers stopped rolling over RRPs and bought US bonds to lock in at least 5% yields. The figure below shows the yields of US bonds of various maturities. The US bonds due in December currently have a yield of 5%. Now a large amount of allocation can keep the high yields provided by the fund until the end of the year, which is a great publicity advantage. Of course, continuing to hold a large amount of RRP can also bring 5.3% yield, but no one will choose to do so. The reason is that as the interest rate cut approaches, the yields of these treasury bonds may attract more buying, causing the yields to fall and the bond prices to rise. The later you buy, the lower the cost-effectiveness.
The decline in RRP balance is just a normal cyclical phenomenon, but the follow-up is worrying
Since the Fed began raising interest rates in March 2022, the amount of new funds flowing into money market funds has been almost equal to the amount of deposits withdrawn from bank deposits. This is because in the United States, the yields provided by money market funds rely on short-term investments in the portfolio, and the returns of these investments are positively correlated with the benchmark interest rate. Large banks such as JPMorgan Chase and Wells Fargo have multiple sources of funds, such as corporate deposits, wholesale funding markets, and bond markets, and are less dependent on personal deposits. This means that they do not need to attract customers by raising deposit rates. Therefore, we see that the Fed's interest rate hikes have led to a widening of the interest rate spread on both sides, with money market fund yields nearly 500 basis points higher than bank deposit rates.
At present, money market funds are gradually replacing bank deposits and becoming the main way for residents to save. Consumers not only transfer bank funds into these funds, but also make daily consumption in them. Therefore, money fund managers need to ensure that they always have assets that can be flexibly converted into cash, and RRP, as an overnight product, is very suitable for meeting this cash demand. At present, retaining $200 billion to $400 billion in RRP seems to have become the bottom line, which means that it is difficult for the RRP balance to be reduced further, and even if it is reduced, there is limited room.
We have said before that the total amount of US dollars in the market can be expressed by the US dollar liquidity formula: "Fed Balance Sheet-Treasury TGA-Reverse Repurchase RRP". The lower the RRP, the more sufficient the liquidity. It seems that the balance falling below 300 billion is a good thing, but it is not. The problem is that the consumption rate of RRP has been so fast this year that it is worrying. The excess liquidity accumulated by large-scale liquidity injections in the past has almost been squeezed out. So, who will act as the "bulletproof vest" for the dollar shortage? Who can continue to take over the huge amount of treasury bonds issued by the United States? The expansion of the Fed's balance sheet seems to be the only way out. Fiscal year 2025 will arrive at the end of September, when the treasury bonds will be under pressure again. Whether a financial crisis will break out depends on the order of liquidity deterioration and the expansion of the Fed's balance sheet. #RRP #扩表 #利率决议
