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In economics and finance, it seems like the authorities use extremely obtuse words deliberately.

Things like quantitative easing, quantitative tightening, yield curve control, negative interest rate policy, operation twist, and on and on.

I believe they do this on purpose so that many won’t even bother to investigate what they really are.

For example, quantitative easing is a fancy way of saying “We are pumping credit (and money) into the financial system to bail out banks and hopefully push prices higher.” But imagine the uproar if they said it that way.

So, alas, they use a big, convoluted word to make it go over our heads.

It’s times like this when I am reminded of what the American musician - Woody Guthrie – once said:

“Any fool can make something complicated. It takes a genius to make it simple.”

Thus, with that said, there’s one specific area that’s critical to financial markets, yet no one seems to be discussing it.

Why not? Well, because it’s a complicated and complex web to get through.

I’m talking about the overnight reverse Repo market (aka ONRRM).

I am worried this market is beginning to show signs of fragility and may have wide implications on markets, the U.S. Treasury, and financial plumbing.

'The Pulse Of The Market'

Now, while the people who set this system up made it extremely complicated (likely to dissuade others from asking about it), I’m going to break it down simply for you.

First - to grasp the impact of these operations on the financial world, let's dive into the basics of the “Repo market”.

Put simply, the Repo Market is shorthand for Repurchase Agreement Market, and every day, the whole financial sector – from banks and money market funds to hedge funds and even the Federal Reserve - deals in trillions worth of Repo transactions. This method serves as the primary means of short-term cash financing, providing liquidity to those in need.

In fact, did you know that the Repo market is a pivotal way the Federal Reserve manages the money supply? They achieve this by either borrowing securities and lending cash or lending securities and receiving cash in return.

For instance, a lower Repo rate incentivizes banks to loan securities to the Fed for cash, thereby boosting the money supply. And conversely, through reverse Repos, the Fed can lend their securities to withdraw cash from circulation, effectively reducing the money supply.

This is why the Repo market is known as the “beating heart of the financial system” – because it keeps blood (liquidity) flowing smoothly without any clogs that could cause a heart attack.

Think of it this way: imagine the repo market as a bustling intersection where cash and Treasury securities meet. A place where assets (like a bond) are sold with an agreement to buy them back, often within a day. It's not labeled a “loan” due to the transaction's structure. But instead, a selling contract includes a clause stating that the seller's repurchase of the collateral shortly after that.

  • I like to think of it as a short-term collateralized loan - where the difference between the original and higher price acts as the "interest," which comes from the “Repo rate” (which is currently 5.3% and under the Fed’s influence).

For example, financial institution A needs $100 million in cash by day's end to settle outflows or any other reason. They will reach out to financial institution B – which could be a hedge fund, money market, or bank - that has spare cash (excess money).

Thus, financial institution A offers $100 million worth of bonds to financial institution B in exchange for the cash.

They both look at it as a win-win: Financial Institution B provides the cash now and collects some yield, and in the future, Financial Institution A will repurchase the bonds back.

I know this all seems like a lot, but it's worth knowing about.

Now let’s talk about the opposite of the repo market – aka the overnight reverse Repo. . .

The Overnight Reverse Repo Market – Why This May Be The Next Problem

So, just as the name suggests, the overnight reverse repo is the opposite of what the Repo market does.

In a reverse Repo, one party buys securities with an agreement to sell them back at a profit on a specified future date (often very soon).

It may seem confusing, but I like to look at it this way:

  • Greater Repo usage indicates there’s too little cash in the system and a glut of collateral (too many yielding assets).
  • And greater reverse repo usage indicates there’s too much excess cash in the system and a shortage of collateral (not enough yielding assets).

And this is the point I want to highlight…

As we all know, after the COVID-19 pandemic struck, the Treasury and the Federal Reserve flooded money into the system (helping spur inflation).

But no institution just wants to hold cash, right? It’s depreciating monthly as inflation compounds.

They want yield (especially since an institution owes interest to savers, thus they need to get income from somewhere first).

Now, normally a bank will make loans to increase income to make sure it’s higher than what they owe to savers.

But after the pandemic, loans (blue line) didn’t grow nearly as fast compared to the money supply (red line).

  • M2 is essentially a measure of the money supply in an economy that includes cash, checking deposits, and other types of deposits that are readily convertible to cash - such as CDs (certificates of deposits).

Figure 1: St. Louis Federal Reserve, 2024

Thus, all this excess cash was sloshing around in the banking system without anywhere to park it (especially since loan demand wasn’t keeping pace).

  • And like a household, you don’t put one million dollars under a mattress. No, you would put it in a bank. But where, then, would a bank park its billions in excess money?

That’s where the reverse Repo market comes in. . .

The reverse repo market is essentially the last resort place for banks to park their excess cash.

And it was so much that by May 2023 – just 10 months ago – there was a whopping $2.4 trillion worth (again, thanks to the Fed increasing the money supply).

This cash buffer of excess cash was parked in the overnight reverse repo market and helped keep liquidity flowing.

But since then, the reverse Repo market has fallen to just $550 billion as of February 22, 2024 – a staggering 75% drop.

Figure 2: St. Louis Federal Reserve, 2024

Why I Am Skeptical Over The Overnight Reverse Repo

There are a couple of reasons I believe for this shocking drop in the overnight reverse repo market.

  1. The Fed continues shrinking its balance sheet through quantitative tightening (QT) – aka sucking money out of the system. Thus, draining banks' excess cash reserves.

  2. The U.S. Treasury is running huge deficits (they ran an enormous $1.7 trillion deficit in fiscal year 2023 – which was almost double1 what it was in 2019). This means that the Treasury is issuing more bonds and increasing the supply of government debt, which institutions use their excess cash to buy instead of borrowing from the overnight reverse Repo market.

Both these things have caused excess money to be sucked out of the financial system.

  • Note that you can’t do two things with the same dollar: either the bank holds the cash or buys a bond.

And with it gone, there could be some hiccups and unforeseen consequences in the financial system.

For instance, if the U.S. Treasury continues issuing debt at a staggering pace, it may stretch banks thin.

To put this into perspective - according to the Congressional Budget Office– the Treasury’s deficit is expected to hit $1.6 trillion in fiscal year 2024. And $1.8 trillion in 2025.

And according to Reuters3, the U.S. Treasury is expected to see debt issuance nearly double to $2 trillion in 2024.

This will require an equal amount of cash to buy these bonds.

  • Remember, to buy the bonds, banks or institutions pay with cash. Thus, with less excess cash in the system, this could cause a problem.

This is a hefty amount of liquidity sucked out of an already fragile banking system that’s dealing with a wall of commercial real estate loans maturing (with large losses expected) and significant unrealized losses on their books.

Such a sudden cash grab by the Treasury will likely intensify banking credit issues.

Or – putting it simply – it’ll suck a significant amount of dollars out of the banking system at a time when cash is becoming scarce.

  • Think of it this way, a shrinking money supply can lead to decreased lending activity as banks have fewer funds to lend out.
    Thus, if all these loans are maturing and likely need to be rolled over (refinanced) in the coming year, it becomes worrying.

Another potential issue is that the Fed may be forced to stop its quantitative tightening (QT) program as excess cash and reserves decline to prevent banks from facing distress - which may re-spark inflationary pressures if they rotate to easing.

See, when the overnight repo market had over $2.5 trillion this time last year, there was enough excess to create a thick buffer.

But now it’s just $550 billion. . .

Will it be enough? At this pace, it may be completely exhausted by summer this year.

Because of this, I am skeptical as the “cash glut” now turns into the “cash shortage.”

It’s almost like you can hear the sound of a sponge sucking up all this liquidity. . .

I will delve into this more in the coming weeks because of how important it is (since there’s far too much to cover). But this was a good first step to hopefully ease you in.

So, in the meantime, keep an eye on this overnight reverse repo market while many ignore it.

And don’t be surprised if cracks begin to show sooner than later.




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