Record U.S. Reverse Repos Highlight Problem Of Investing Excess Cash

Demand for the Federal Reserve's reverse repurchase (RRP) facility has surged in the last few weeks, as the U.S. Treasury Department's reduced supply of short-term bills left investors few options to park excess cash.

Reverse repos are conducted by the New York Fed's Open Market Trading Desk. In a reverse repo, market participants lend cash to the Fed, usually overnight, at an interest rate of 80 basis points, in exchange for Treasuries or other government securities, with a promise to buy them back.

"We continue to see a grind higher in RRP balance," said Gennadiy Goldberg, senior rates strategist at TD Securities in New York.

"That's a function of two things: first, the extreme high demand for front-end assets, and second, the amount of bills outstanding has continued to decline as Treasury has cut back supply because of fairly strong tax collections," he added.

The Fed's reverse repo window attracted a record $2.045 trillion on Monday, as financial institutions continued to flood the facility with liquidity in exchange for Treasury collateral. Monday's volume was one of a string of record highs for RRPs.

Investors are guaranteed 80 basis points for overnight cash without counterparty risk.

This compares with the current 51 basis point yield of U.S. one-month bills, whose longer maturity carries more risk.

On Tuesday, the RRP volume slipped to $1.987 trillion amid the outflow of cash from government-sponsored enterprises Fannie Mae and Freddie Mac. The repo market is largely affected by the flow of cash from GSEs.

Cash from Fannie Mae and Freddie Mac typically enters the repo market on the 18th of each month when they receive principal and interest mortgage payments from home lenders. GSEs then pay mortgage-backed security holders around the 24th to the 25th of the month, withdrawing that cash from the repo market to pay MBS holders.

SHRINKING BILLS SUPPLY

As the U.S. budget deficit shrinks amid robust tax revenues, the Treasury will have to aggressively shrink bill issuance through Sept. 30, analysts said.

"A sharp decline in bill supply will push much of the money fund cash into the Fed's RRP, draining bank reserves by more than $1 trillion this year," said Joseph Abate, managing director, fixed income research, at Barclays.

He expects bill supply to shrink 15% between April 1 and Sept. 30.

"It's really a double whammy on the front end because of too much demand and not enough supply, leaving the RRP facility as the option of last resort for many investors," said TD's Goldberg.

The soaring RRP volume does not seem to be a concern for the Fed given that quantitative tightening will only begin next month. But it could be a problem if demand persists even after the Fed's asset portfolio starts to shrink, said Lou Crandall, chief economist at money market research firm Wrightson.

He noted that a number of Fed hawks last winter cited the bloated RRP facility as a reason to start cleaning up the Fed's balance sheet through asset runoffs sooner rather than later.

"Individual FOMC (Federal Open Market Committee) members might start to weigh in on the topic if RRP volumes move north of $2 trillion this summer," Crandall said.