Understanding the Fed’s RRP Facility

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Peter Maiorano: I don’t know if the Fed actually thinks that there is a problem. In that, I think the Fed views this as their facilities being used for the reasons that they put it there, and put it in place. And I think they see it as helping the market function. If you’re on the money market fund side, you think there’s a huge problem.

Bipan Rai: Hello, everyone, and welcome again to another edition of The FX Factor podcast. I’m your host Bipan Rai, North America head of FX strategy here at CIBC. For today, we’re going to delve into the repo market, particularly in the United States, which has become a pretty hot topic of late for reasons that we’ll get into. But first, let me introduce our guest. He is the bank’s expert on the U.S. repo market, Peter Maiorano. Peter, welcome to the podcast.

Peter Maiorano: Hey, Bipan, thanks for having me.

Bipan Rai: Excellent. So in a nutshell, I mean, from a 15, 20 thousand foot view, what is the main problem in the U.S. repo market right now?

Peter Maiorano: Yes. So repo rates have been trading at either side of zero for the last month or so, at times even trading at negative rates in between banks. And it’s creating a problem for money market funds who invest in overnight repo. And so they’re getting very, very low return on their cash. And in fact, we’re seeing a lot of cash from the money market funds and others with cash to invest in repo going to the Fed at the Fed’s reverse repo program and getting zero rate on their money.

Bipan Rai: Right. So let’s talk about the Fed’s reverse repo program, because I guess that it ties into what I want to eventually discuss, which is what the facility is, why it’s important. Can you talk a little bit about that and explain a little bit to the audience about why the Fed implemented this overnight facility?

Peter Maiorano: Yeah, sure. So you had the Fed put the reverse repo program in place to put a floor under the repo market and to provide a venue where money market funds and people who have cash to invest could get at least some minimum rate on their money. The Fed’s got a target of zero to twenty five basis points and where they’re trying to keep the Fed funds rate and what IOER and the Fed reverse repo do, or sort of keep a floor, try to support the floor for the Fed at their targeted rate.

Bipan Rai: Ok. When the Fed is targeting rates, we’re obviously talking about the amount of reserves that commercial banks have with the Fed. So let’s talk a little bit about the Fed’s tools and how it manages them. Can we talk about its quantitative easing program and how it impacts the balance sheet?

Peter Maiorano: Sure, yes. So quantitative easing was one of the ways that the Fed jumped in to calm the markets and add liquidity back when covid first hit back in March or April of last year. And quantitative easing, QE, as it’s called, is where the Fed is buying US Treasuries, mortgage backed securities. They were even buying corporate bonds at one point earlier on in the program. That takes some supply of bonds out of the market, adds cash and liquidity into the market. And the Fed’s balance sheet, as a result has grown dramatically. If you look at the Fed’s balance sheet back in February of last year, it was probably around four trillion dollars and now it’s somewhere right around eight trillion. So it’s a dramatic increase in the Fed’s balance sheet.

Bipan Rai: Right. Again, that dramatic increase in the Fed’s balance sheet means that there’s just that much more cash circulating in the financial markets right now. So, I mean, why is there so much cash that shifting into money markets? Think speak a little bit to that Peter?

Peter Maiorano: Yeah, sure. So it’s a combination of the QE that we just talked about is putting a lot of cash into the system. There was also a change in the regulatory framework where March 31st, the exemption for SLR was up for renewal or not, and the Fed decided not to extend the exemption to banks for on the SLR treatment of how US Treasuries and deposits at the Fed were treated on the banks balance sheets. So by not extending that, that ended up reducing the amount of treasuries that banks held and their willingness to, to hold as many deposits. Right. So, cash ended up shifting from banks over to money market funds for that reason. And then there’s a lot of cash also from the fiscal stimulus that we’re seeing from the government with all these programmes that have been put in place to alleviate the effects of the pandemic.

Bipan Rai: Right. So we’re really talking about a three pronged sort of push towards cash here. I mean, you mentioned the QE and also the fact that that’s increasing. And we’ve seen that regulatory change really does put a lot of additional pressure that from what I understand into this cash moving into Money market funds, but I mean, isn’t there also the risk? I guess this risk has been around for a while with the Fed setting policy with money markets instead of, say, intermediaries like commercial banks in the past?

Peter Maiorano: Yes. So the Fed’s not exactly setting the policy with the money market funds, let’s say, in that they’re going to tweak the rate that they pay on the Fed reverse repo or the IOER are to, you know, try to keep the Fed funds rate within their target range of zero to twenty five basis points. And because those rates have been hovering on the lower end, that is the predicament that we’re in, if you will, where repo is trading at abnormally low rates.

Bipan Rai: Right, And so if money market funds have a sort of influx of cash coming in and what is the risk there if that continues, it is left unchecked, does that mean that at some point in money market funds are going to start demanding higher yields from the Fed for the use of the facility?

Peter Maiorano: That’s a great point. I think right now the prevailing wisdom would suggest that the Fed is going to, quote unquote, tweak their short term rates up, meaning the rate that they pay on the Fed, reverse repo and IOER. And those will be looked at as technical adjustments that the Fed is making. Not anything that is a foreshadowing of any policy from the Fed, but just technical slight rises in the rates that they’re paying on cash, which most people feel will be announced at the FOMC meeting this mid-June. And in doing that, it doesn’t really solve if you view the problem as the amount of cash that you’re seeing in the Fed reverse repo. If you view that as a problem, then it’s not going to alleviate that. The higher rates being paid by the Fed is not going to lower the amount of balances that we’re seeing at the Fed reverse repo. But it will help the money market fund community in that they’ll be able to get, you know, a higher yield on their cash, which is good for them and keeps them healthy and keeps that industry out of trouble for the Fed reverse repo numbers to actually the balances at the Fed, reverse repos for that to actually go down. I think what you’d have to see there is a larger scale change that may come from the Fed reducing the amount of its bond buying and reducing the QE that would allow more supply of Treasury and mortgage collateral out into the market, into the hands of more leverage players who need to go raise cash to, to fund those positions that they take. So until and if you see the Fed start to ease up on its bond purchases, I don’t predict that you’ll see a large decrease in the amount of cash at the Fed reverse repos.

Bipan Rai: Right. What about the odds at this overnight reverse repo facility is made permanent. Do you see any chance of that happening?

Peter Maiorano: Yeah, I think that the facility is meant to be there in perpetuity. I don’t think it’s got an end date on it. And I think, you know, it’s a good tool for the Fed. I think, you know, it’s interesting because even looking at this as a problem, let’s say, I don’t know if the Fed actually thinks that there is a problem in that I think the Fed views this as their facility is being used for the reasons that they put it there and put it in place. And I think they see it as helping the market function. If you’re on the money market fund side, you think there’s a huge problem because you’re not getting any return on your cash. So if the Fed tweaks their rates and the money market fund complex is able to get a better return on their cash, but if you even saw the numbers at the Fed reverse repo go from four hundred and eighty billion to a trillion dollars, I don’t know that the Fed would think that’s a problem in and of itself. I think that they view it as, you know, the facilities working. It’s there for a reason. A month or two ago, the Fed increased the limits on how much each money market fund can go into the reverse repo for from 30 billion to 80 billion. I think the Fed foresaw that there was going to be a big demand in their reverse repo facility and addressed it sort of up front and they could continue to tweak that higher if they need.

Bipan Rai: So, I mean, I guess another question that I wanted to ask is, if the Fed foresaw this and it didn’t really have an issue with the amount of usage of the overnight facility, what was the motivation to end up altering the SLR? For those listeners that aren’t familiar, the SLR is basically the supplementary leverage ratio. What was the motivation to really alter that at the towards the end of Q1 this year?

Peter Maiorano: Yeah, I think the rationale behind that, I think, is purely that the Fed felt that the banks were in very strong capital positions and that exemption was no longer needed. They probably did envision that there could be some downstream effects of that, that they could handle those issues with the programs that they already had in place. So, yeah, I think the Fed not extending that exemption was just purely based on the fact that they felt that banks were strong financial institutions and that their Capital positions were healthy enough to end that exemption.

Bipan Rai: Right. I mean, the timing couldn’t have been worse because I believe that was right around the time that the Treasury said there’s was going to start spending and drive down on its Treasury general account. If I’m not mistaken. And so another question I have for you Pete is you mentioned that there’s going to be a technical adjustment coming up at the Fed meeting in June. What specifically are you looking for? Because I have heard a few places mentioned that five beeps was a consensus, but now I’m hearing more and more about potential 3 beeps hike for both the IOER and the reverse repo facility rate. What do you think? There’s not that much of a difference between the two, but are you more inclined to go with five beeps?

Peter Maiorano: Yeah, I feel I’ve heard both. As you mentioned, my inclination is to think that they would do three basis points. I think, you know, this is a purely technical adjustment that they’re trying to make. I think three basis points would suffice. But again, as you mentioned, whether it’s three or five, it’s probably not the end of the world either way. But my inclination is to think they would do three.

Bipan Rai: And bringing it back to FX, really, if we’re talking about a technical adjustment, like Peter says, with respect to the IVR and reverse facility rate, that doesn’t really mean much for the U.S. dollar. In fact, the more important signal could be the Fed were to at least start discussing tapering its QE purchases over the coming months. That would be far more important for the dollar. So, again, we want to reiterate our view that technical adjustments, like the one that Peter mentioned, probably won’t matter as much for the dollar over FX markets in the here and now. I think we covered a lot of the ground that I wanted to touch on today, Peter. And I wanted to thank you again for joining us on this episode. We’d love to have you back whenever something interesting happens again in your market.

Peter Maiorano: This has been great. Thanks for having me.

Bipan Rai: Cheers.

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