personal views of a former fed trader

Tag: ON RRP

The Reserve Gap

A rapid decline in the level of bank reserves would be an obstacle to QT that may prompt action from the authorities. An aggressive QT was premised on first draining the large RRP balances, but the monetary plumbing suggested that was never likely. Banks can easily maintain their own reserve levels, but their own target levels are significantly below those of the Fed. This implies that bank reserve levels will likely fall below the Fed’s comfort level far before QT is slated to end. In this post we sketch out the Fed’s dilemma, show why its options are limited, and suggest that Treasury buybacks or SLR adjustments would likely be used to boost bank reserve levels.

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Turbo Tightening

The money supply is set to contract just as investors are clamoring for cash to hide from declines in both equities and bonds. A combination of increasing MMF allocation to the RRP and QT may drain ~$1t of bank deposits by the end of the year. The Treasury’s decision to further cut bill issuance will keep money market rates very low and likely push the RRP to over $2.5t by the end of the year. Furthermore, recent history suggests QT will largely be funded by deposits held in banking system rather than the RRP. The combination of these two mechanisms suggests a net contraction in bank deposits despite elevated bank credit creation. Investors looking to hide in cash will have to compete for a shrinking pool of cash by further lowering the asking prices of their assets. In this post we describe the mechanics behind the impending rapid withdraw of cash and suggest the market rout will continue.

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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.

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The Elasticity of 5 Basis Points

Large money market investors will move billions for even a basis point. A 5bps increase to the RRP offering rate led to a $200b+ surge in participation, but there is a wrinkle to the story. The bulk of the increase likely came from Government Sponsored Enterprises (“GSEs”) who were leaving hundreds of billions at 0% in their Fed account, so it was not an incremental flow from the private sector. That being said, the 5bps increase puts money market funds (“MMFs”) in a position to offer their investors a few basis points in yield. This will make it easier for banks to continue to push out their high cost deposits. The departed deposits will quickly be replaced by the constant flow of low cost deposits created from Fed financed deficit spending. In this post we shed light behind this week’s RRP surge, the improving funding profiles of banks, and why this means FRA-OIS will continue to narrow.

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ON RRP Take-Up Will Go Much Higher

The humble ON RRP is in the spotlight as take-up marches steadily upwards. It will go much, much higher. Increasing participation is largely a function of two structural forces in the financial system: on-going Fed QE ($120b/month) and Basel III constraints. On the margins, changes in the level of the TGA have some impact as well. Water pouring into a glass remains in the glass, until the glass is full and then every incremental drop overflows. The Fed has been adding tremendous amounts of liquidity into the financial system over the past year, and there was initially very little take-up in the ON RRP. But now it appears the banking system is full – Basel III constraints are becoming binding. The incremental QE deposits are flowing out of banks and into MMFs, and then down the ON RRP drain. The system is working as intended. In this post we review the cause of increasing ON RRP take-up, note that high take-up will be a permanent feature going forward, and suggest that money market rates will fall below the ON RRP offering rate.

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The ON RRP Will Never Be A Floor

The Fed would like the ON RRP to play a bigger role in its rate control framework, but the ON RRP has been and will always be a very leaky floor for money market rates. From 2016 to early 2018, Treasury bills and agency discount notes consistently traded several basis points below the ON RRP. Today, even tri-party GC repo is occasionally dipping below the floor. The floor will only get leakier as money floods into the front end: QE continues to pour $120b a month into the banking system, the TGA continues to decline, and banks continue to shed low quality deposits. In this post we review how the ON RRP transmits policy rates, why the global nature of the dollar system means it will always be a leaky floor, and why even a ON RRP rate adjustment may not protect the 0 percent lower bound.

The ON RRP has been a very leaky floor for money markets
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