Reverse Repos Ramping
The Federal Reserve Reverse Repos have been getting a lot of attention in the economic and financial wonky blogosphere, as we have seen the volume spike. Should we be concerned? Is this a sign they are about to raise rates and use the reverse repos as an alternative way to control rates? Is there possibly a big problem in the banking OTC sector? There are lots of skepticism, implications, and conjecture.
Reverse Repos Ramping
For those not familiar with a Reverse Repo it is similar to a collateralize loan with a guarantee payback.
- The borrower, a person/institution with securities (bonds, stock, other financial asset), exchanges the securities for money, with an agreement to buy back the securities at a later date for a guaranteed price.
- The lender lends the money for the securities, with the promise to sell the securities back for a guarantee price by a certain date.
The repurchase price is usually (not always) greater than the original price. This difference represents an interest rate, commonly known as the “repo rate”. Effectively the borrower of the money is paying a higher price to get the securities back, thus paying a fee to the lender that is similar to interest.
First we must remember the Fed has bought (and continues to buy) trillions of dollars in government bonds. The Fed will use these bonds as securities to lend to the banks in exchange for cash (from money market and bank deposits) and through the agreement guarantee to buy back the bonds as a higher price, thus paying interest to the banks. This will equate to the amount the money markets are paid in interest.
The Federal Reserve has decided to use the Reverse Repo program as a tool to help raise rates in a controlled fashion. The Fed wants to control the top and bottom of the over-night lending rate via two interest rates. The top of the range is controlled by the interest rates the Fed pays banks on their reserves placed at the Fed. The bottom will be the interest rate paid through the reverse repo program. The floor rate set by the reverse repo is to help set money market rates.
The Fed started testing this program in late 2013 with a $300 billion dollar a day cap. Think about it for a second, they are testing $300 billion per day in reverse repos, that’s a mighty big test. There is certainly significant risk, because bond prices fluctuate and the risk of inflation means the money they payback could be worth less.
This is a new program and its magnitude is enormous, no one knows how the variables will impact the program. The Fed has been concerned about the relying heavily on the reverse repo facility because of its size and it really has never been used to such an extent.
According to the March 2015 FOMC meeting minutes, the Fed has agreed to lift the $300 billion per day cap and let this thing go. Some at the Fed are very concerned this is a new can of worms that could come back to haunt the Fed that are bringing new unknown risks to the banking sector. Even Chairman Yellen has noted caution as she stated they would only use it to the extent necessary to help try and control Fed Funds rates and wants to phase it out.
Phase it out, extent necessary? They are just starting the program, it’s not going to be phased out and it is going to be far larger than what she hopes to be necessary.
Courtesy of FRED
Discount Window Collateral?
The Discount Window is when the Fed lends money directly to member firms (banks) for a nominal rate. Traditionally banks only go to the “Discount Window” when they are in trouble and do not have enough money and/or cannot borrow enough from other banks to carry their debt. Banks do not like to ever report they needed to go to the Discount Window to borrow money, because it means they are in trouble and could cause a “run” at the bank. During the Crisis (2008-2010) we saw lots of banks going to the Discount Window to stay afloat, it was like a short-term bridge loan to stay in business. Bernanke was once asked which banks were going to the “Discount Window”, during the crisis – he would not say as he was concerned it could cause a run.
Courtesy of FRED
One criticism that has been bantered about is that the reverse repos can be used as collateral alternative to the discount window lending. It can also effectively be longer-term lending via (repo-rolling), which is nothing more than an accounting trick. If the lender (the banks) can consider the repo an asset with AAA credit (because it is a government bond), it could be used to increase their borrowing capacity. That means it could find other lenders and when things go south even be used at the Discount Window when/if necessary.
Funding Default Risk
Some have criticized that the Reverse Repo program can be used to shore up banking collateral when an over-the-counter (OTC) loan has gone bad. Much like the explanation for the Discount Window collaterally, the treasuries can be used to build collateral against OTC asset risk.
Several stories have surfaced about derivative and bank OTC risk with the likes of Glencore, Deutsche Bank, VW, and a few others that are exposed to huge private loans and OTC assets that may default (or have). There certainly has been a big spike in the Reserve Repos that happens to coincide with the realization of these huge risk factors.
Glencore is suspected to have $100 billion in debt risk and with the stock losing value and their debt becoming junk, those banks that lent the money to Glencore and/or hold OTC derivatives could be on the hook for billions. The conjecture is that these banks are jumping into the reverse repo market to shore up capital collateralized with government bonds from the Fed.
Additionally Deutsche Bank has announced huge asset write-downs exceeding $7 billion this last quarter and is the world’s largest OTC derivative player. Concerns about Deutshe Bank’s risk have also drawn some concern.
The evidence is certainly compelling, but we must understand it is conjecture. Could the spike in reverse repos be a signal that there is huge default risk in the derivative OTC and bank lending?
Back Door QE
Another conclusion is the Fed is using Reverse Repo facility to generate cash needed to continue their bond buying program. Remember that while the Fed said they ended QE3, they did NOT end their bond buying program. They have admitted as much in their own FOMC statement:
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”
The Fed faces two problems; the Fed is running out of maturing bonds to continue to current pace of bond purchase to meet the government demand. Second problem is that this has compounded recently as huge foreign reserves, such as China are now net sellers of U.S. bonds.
The Fed either needs to ramp up money printing and announce another QE to start bond purchases or find another way raise short-term capital purchase bonds. The reverse repo facility is certainly a way to sell bonds and raise capital to buy more.
Is it coincidence they started to test the reverse repo as they were winding down QE3 and now lift the $300 billion dollar daily cap as foreign reserves are actively selling bonds?
This seems one of the more plausible answers as to what is going on with the reserve repos, but the other speculation can certainly also be factor.
Courtesy of FRED
Inflation and Bond Risk
There are two risk factors that no one, not even the Fed, has fully addressed. That is who will be on the hook if bonds decline sharply and/or inflation spikes?
The one overarching argument against the reverse repo program has been that you are SHIFTING liabilities from the Fed’s balance sheet to the savers in banks. Technically the banks are holding bonds at their all-time low interest rates (or high bond prices) and if rates rise/bonds fall the banks and ultimately the savers are on the hook. You could see not just negative rates on money markets, but actual losses on money markets.
If the Fed is lending the bonds to the banks and they devalue, but the Fed is forced to buy them back the Fed could be on the hook. However, the Fed could also default and NOT buy the bonds back, leaving the banks holding bonds that have declined significantly. Banks would then need to hold them to maturity to get any principal back. Not that the Fed would do that, but they could. Someone is going to have to take the loss, the Fed or the Bank. We all know it is not ultimately the bank or Fed that will eat the loss, it will be the taxpayer, either through inflation (which is a tax on money) or through direct losses in money market accounts. It will not be a good scenario.
The other risk is inflation; the current repo rate is not even on par with current inflation rates. Higher inflation means that money markets are paying negative real returns.
Unless you are an economic and monetary policy wonk you are probably not aware of the size of the reverse repo market or even know what it is. However, this is already becoming a massive market and there are certainly risks as well as problems that could be masked by what is going on in this 100s of billions of dollar market. How does it impact the dollar, interest rates, inflation, bonds prices/yields, and ultimately risk in the financial sector?
It has been truly untested and at this magnitude no one knows what could happen and what is really happening behind these 100 billion dollar trades.
I am not one to jump on the conspiracy band wagon, but looking at some of the bank earnings this week, buy-backs, Glencore and other bank issues, combined with the ramping up of reverse repos, something is going on.
Unfortunately it will probably not make financial news headlines until something has imploded and some have suggested something already has by the size of the recent reverse repo volume.
Support & Resistance
INDU 16,800 – 17,400
The action this week looks like we are losing steam and starting to stall out just above 17,000. I think we could pull-back this week and test 17,000. If we crack, a move back down and sharply to 16,800 is in the cards.
NDX 4300 – 4400
The uptrend is stalled and a move to 4300 this week is a real possibility. It could happen quickly and just be an intra-day move before we bounce.
SPX 1980 – 2060
While this is a broad range, we stalled and are coming back down to 2000. See if we can hold there on any volume. A close on the low and below 2000 means a visit to 1980 is in the cards.
RUT 1140 – 1180
Russel continues to be the guide and we are heading lower. The question now is whether 1140 is support or we see a route that sends us to 1120. Watch volume and how the market closes.
I can’t help but wonder if something is going on behind the scenes. The massive reverse repo volume is a sign that either the Fed is relying on this new lending system to control interest rates or are using it to collateralize big problems, whether it’s the Fed’s need to buy bonds or help possible huge defaults.
Something is going on and no one is talking.