personal views of a former fed trader

Draining the RRP

The $1.7t in the RRP can help finance the upcoming deluge of coupon Treasuries, but it won’t be easy. Treasury bills will easily be funded, but the bulk of the upcoming supply from net issuance and QT is likely coupons. There are only two ways the RRP can finance coupon Treasuries: 1) funding repo loans to leveraged Treasury investors or 2) funding money fund redemptions to cash Treasury investors. Both mechanisms are subject to frictions that suggest a messy process. Leveraged investors may encounter dealer balance sheet constraints, and cash investors may need a much steeper curve. In this post we describe the two mechanisms and highlight the potential for an “air pocket” in the Treasury market where the marginal buyer is many, many ticks away.

Two paths RRP money can flow into coupon Treasuries

Leveraged Investors

The pipes through which RRP money flows to leveraged Treasury investors may not be wide enough to finance upcoming supply. Leveraged investors are “fast money” investors who can quickly borrow large sums of money to take advantage of market dislocations. Money flows to them through dealer balance sheets, which are the main “pipes” of the financial system. Cash investors lend to dealers, who relend to leveraged investors, who then use the cash to purchase Treasuries. This transaction “expands” a dealer’s balance sheet because it adds both a repo asset (loan to hedge fund) and a repo liability (loan from cash investor). In theory, money market funds (“MMFs”) can shift their investments out of the RRP and into repo loans that end up funding Treasury purchases. But in practice, balance sheet constraints will limit this flow.

The GFC marked a fundamental shift in market plumbing

The pipes today are narrower than they were pre-GFC even as the size of the Treasury market has exploded higher. Dealers were borrowing $3t in repo on the eve of the GFC, but only $1.5t at the end of 2021. The decline is in part due to regulatory changes that penalize large balance sheets. At the same time, the supply of Treasuries has increased from $5t to $23t and counting. This suggests that the leveraged community will ultimately run out of financing even if they do want to buy Treasuries. Note the Fed’s new Standing Repo Facility does not help since the constraint is not cash available, but balance sheet.

A new financial product called Sponsored FICC is widening the pipes, but it won’t be enough. Sponsored FICC allows a dealer’s clients to engage in nettable repo, which conserves the balance sheet space of dealers. A dealer who borrows and lends $100 in nettable repo can net the two legs of the transaction so its balance sheet size is little changed. Sponsored FICC is growing in popularity but does not yet appear to have a high level of participation among leveraged investors.

Sponsored repo has big potential, but participation is still a relatively small part of the market.

Cash Investors

Money in the RRP can also make its way into the Treasury market indirectly via MMF investor redemptions. In that case, an investor withdraws cash from a MMF and uses it to purchase Treasuries. The MMF in turn meets that redemption by withdrawing money from the RRP. The relative importance of this mechanism is hard to gauge because a wide range of investors hold their cash in MMFs. The largest investors type in MMFs are households, which is a category that includes a diverse set of participants from retail to hedge funds. However, there are macro forces that are working to disincentivize MMF withdraws.

Households increased their MMF holdings significantly, perhaps in part due to fiscal stimulus.

The Fed’s expected rapid hike cycle and high inflation suggest investors have less reason to move out of MMFs and into longer dated Treasuries. MMF returns will rapidly rise if the Fed follows market expectations and hikes to over 2% by year-end. The relatively flat curve means investors would have limited yield pickup by moving out the curve. In addition, rising inflation is increasing the cash needs of investors as everything costs more. A meaningful investor shift out of the front end and into other segments of the curve may require a materially steeper curve.

Air Pocket

With a large RRP more bark than bite, the Treasury market may come under strain from the massive upcoming supply. There is reason to think the world’s most liquid market is actually fragile. Over the past 20 years, Treasuries outstanding rose 7 fold while daily cash volumes only rose from $370b to $620b. This suggests a market with steadily deteriorating liquidity, which means any potential tremors will be magnified. Rising rate vol indicates that liquidity is evaporating, and the events of March 2020 have already shown that the cash Treasury market can run out money. Trillions more of Treasuries will soon flow into the market to test its resilience.

Market liquidity has not scaled with the size of the market

The QT timebomb is ticking. When it goes off there will be emergency liquidity operations, and we will move to the YCC end game.

15 Comments

  1. Owen

    Would reinstating SLR exemption and/or encouraging greater use of the standing repo facility help? Thank you 🙏🏽

    • taproot

      In theory yes. Personally I think they will prob have to augment SLR sooner rather than later. I mean in reality is the only way to fix the markets if they break via, rising rates/QT

  2. AJ

    Hi Joseph,

    Love what you write & a big fan – but a few clarifications needed for me as “some factors” don’t add up (I’m a novice , so please correct me if I’m horribly wrong)

    1) RRP money can get back via MMF investor redemptions? : Since July 2021, we seen RRP move up nearly $1 trillion but MMF (MMFA index) almost the same – so when u say via MMF redemptions , isn’t RRP NOT a subset of MMFA holdings & RRP money could simply just move into MMFA holdings (whole reason I thought RRP built up was MMFA yields were too low that investors re-deployed into RRP v/s MMFA)

    2) Is dealer balance sheet really a constraint with Fed standing repo ?: I hear your concern on dealer B/S constraints but doesn’t Fed standing repo solve for that issue – risk of course is Fed B/S may eventually rise again due standing repo increase (sometime in future) ?

    Love to hear your views and thanks again for the awesome work you do

    • William Sperry

      normal investors dont have access to the RRP, they have to invest in MMFs which then put some of the money into the RRP when its the best they can get.

  3. Engin YILMAZ

    There are only two ways the RRP can finance coupon Treasuries

    Wang,
    Could MMF directly buys TS with using RRP ?
    The following new article explains this
    The Fed’s Balance Sheet Runoff and the ON RRP Facility

    sincerely
    @veridelisi

    • taproot

      MMFs can buy bills. I don’t think they can just buy longer dated securities tho

  4. Kolya Krece

    I don’t think the Fed will have much political room to do yield curve control if inflation is still high. They are now in a box and savers might finally have a chance to earn real returns on their capital.

    • John G

      With the amount of debt outstanding they cannot let interest rates go much higher or it’s game over. YCC will need to be done to keep real yields below inflation. See 1940’s for example.

      • Engin

        John
        Is there spesific article?

        • Teddy

          Read @lukegromen. He has written extensively on the subject in tweets, newsletters, and books.

      • Kolya Krece

        An economy that depends on the continual confiscation of the wealth of money holders and fixed income investors to subsidize governments and borrowers is not a sustainable economy. Yield curve control will not fix that issue either politically or economically.

      • HJ

        i thought real yield is already way below inflation thats why nominal GDP is forecasted to be around 5% while 10y yield is at 2.78%…im confused.

        • Hans Overturf

          The GDP 5% projected growth rate is real, not nominal. It if was real, we would be in a recession, given that inflation is running around 8%.

  5. Jamie Diamond

    Josept, I never imagine US adopting YCC before but now with current backdrops, YCC is very plausible It seems… but the problem is what level is an appropriate for curve control? 10yr at 2.50? or .75? how is it usually measured?

  6. Hector

    Hey Joseph, quick question: when the time comes to pivot from tightening to easing, I assume the Fed will utilize the $2T sitting at the RRP by reducing the RRP interest rate and pushing all that excess of cash into Tbills. That way, the Feed will feed the Tbill market without engaging into actual QE themselves.

    Do you see the Fed reducing the RRP rates ahead of reducing the actual Feds fund rates for this purpose?

    Thanks!

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