The Fed Is Preventing Negative Interest Rates Using Reverse Repos

Reverse Repurchase Agreements on the Fed’s balance sheet have surged from $0 in mid-March to $535 billion on June 10th.

Many people have begun to ask if the suddenness of this development portends a new crisis in the financial markets.

It doesn’t.

The latest Macro Watch video explains what Reverse Repurchase Agreements are and why they have surged.

It shows that the Fed is using Reverse Repos to prevent short-term interest rates from becoming negative in order to prop up the $4 trillion Money Market industry and, thereby, avoid any disruption to the credit markets that rely heavily on Money Market Funds for overnight financing.

Finally, the video also explains that the jump in Reverse Repos is holding down the level of Bank Reserves, which may be preventing stock prices from moving even higher. Bank Reserves would have been more than half a trillion dollars larger if not for the increase in Reverse Repos since mid-March. That probably would have driven stock prices to yet higher highs.

The big picture is as follows:

The Fed is injecting $120 billion of Liquidity into the Financial Markets through Quantitative Easing every month in order to hold down long-term interest rates to help the Government finance the very large budget deficits that have resulted from the Covid pandemic.

At the same time, it is using Reverse Repurchase Agreements to prevent the Liquidity it is creating from driving short-term interest rates negative.

So far, this strategy is working. Long-term interest rates are relatively low and short-term interest rates haven’t turned negative.

So, there is no reason to worry that the surge in Reverse Repos suggests that some kind of crisis is brewing in the Financial Sector.

However, if the amount invested in Reverse Repos continues to grow much larger, that would drain more Liquidity from the Financial Markets (by shrinking Bank Reserves). That could cause headwinds for stocks and other asset classes. Therefore, investors will need to monitor developments here closely during the days and weeks ahead.

Macro Watch subscribers can log in and watch this video now for all the details.

It is 14-minutes long and offers 41 slides that can be downloaded.

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