What’s up with the Fed’s RRP?

Peter Maiorano: As you pointed out, money market funds are, I guess, 95% of the balances in the RRP. All of the answers to our questions about the volume or the balances in the RRP kind of stem from what has to change either in the marketplace or what is going to alter the behaviour of the money market funds that are parking so much of their cash in the overnight RRP.

Bipan Rai: Hello, everyone, and welcome to yet another edition of The FX Factor podcast. This will be our final edition for 2022. So we want to wish everyone listening a safe and happy holiday. And of course, we wish you all a very prosperous 2023 This time my guest is Peter Maiorano from our Global Collateral Finance desk. Pete’s been on the podcast before and has helped us make sense of the US repo market ahead of what should be a very interesting year when it comes to the plumbing of US markets. I wanted to have Peter back on to just sort of talk about some of the more topical themes that are emerging in that space. And of course, for those of us that focus more on macro assets, there will be some broad takeaways and implications for what to watch for going into next year. We’ve got several items to cover, but I think the most pressing ones are, of course, the Fed’s quantitative tightening program and how that’s playing out over the background and also uncertainty with what’s happening with respect to the Fed’s overnight repo reverse repo rate facility. Pete, welcome to the podcast.

Peter Maiorano: Thanks a lot, Bipan. It’s good to be here. Thank you.

Bipan Rai: Excellent. So why don’t we start off by reminding our listeners what exactly the Fed’s overnight reverse repo facility is?

Peter Maiorano: Yeah. So that’s you know, that’s a program that the Fed put in place in order to allow money market funds and others who are holders of, you know, large amounts of cash to be able to get a rate on their cash. And it began back when the target on the funds rate was 0 to 25 basis points. And overnight repo was sometimes trading through the floor on the target on the funds rate, sometimes trading through zero. So the Fed put this in place as a mechanism for those holders of cash to sort of have a floor beneath which they didn’t have to go to invest their cash.

Bipan Rai: So the latest data still shows that the take up of this facility is north of 2 trillion USD. Originally we had expected that the Fed’s quantitative tightening program, which effectively burns deposits in the US banking system, would have meant that money market funds would have reduced use of this facility. Peter, why hasn’t this happened as of yet?

Peter Maiorano: Yeah, no, that’s a great question. Certainly a year ago today, you know, I would have been sort of the camp that the balances in the RRP would have been coming down sort of starting by, you know, the September, October time frame of 2022. And that really hasn’t materialized. I think a couple of things have transpired to create the situation. As you pointed out, money market funds are, I guess, 95% of the balances in the RRP. All of the answers to our questions about the volume or the balances in the RRP kind of stem from what has to change either in the marketplace or what is going to alter the behaviour of the money market funds that are parking so much of their cash in the overnight RRP. And it seems to me that it’s, you know, it’s a couple of things. One is we’ve gone through a year of some, I guess I would say unprecedented or historic rate rises, right? So when you’re in that type of environment, it’s a pretty natural desire for people to keep their investing short term in nature, right? And they’re not really willing to extend very far out the curve. So, you know, a lot more money was getting parked way up in the front end of the money market space and in overnight repo because of that Fed hiking posture and the speed with which they were hiking and people just unwilling to extend. So that’s, I think, one part of that equation. So the QT really started just to kick in in earnest in September of this year at around 95 billion a month. So I think over the course of 23 you’re looking at another roughly trillion dollars’ worth of treasuries and or mortgages that are in circulation and could end up in the hands of more levered players. And then so those players looking for funding. And then I think what I’ve read is that you could see upwards of an increase of $1,000,000,000,000 in the supply of Treasury bills as well, right? So if we get more supply in the money market curve, coupled with the fact that money market funds as the Fed sort of gets to the tail end of their hiking cycle over time, over the next few months, we should start to see if we haven’t begun to see it a little bit already a willingness on the part of money market funds to extend out the curve and take some duration. I think those two things or three things, you know, really boils down to two things, the supply of money market collateral, i.e. T-bills, plus the willingness of the money market funds to extend out beyond the very, very short term in light of the Fed, you know, presumably coming at some point in the not too distant future near the end of their hiking cycle. And then, you know, so call it, I would say mid-2023, you know, we should definitely start to see reduction in the RRP balances. And you know, we’re up over 2 trillion, as you noted, close to 2.2 trillion. So I think if we get by May, June, if those balances are running sort of in the 1.5 trillion zip code, I think we’re heading in the direction that you and a lot of others have been thinking that we would be.

Bipan Rai: Okay. That was a fantastic response, Pete, really enjoyed that. So another follow up question to that then, if money market funds are actually going to look at extending out the curve, I mean, what does that mean really for the banking system? Does it really change or alter the configuration of what we’re seeing in terms of deposits right now? Are we going to see a further sort of attrition of deposits going forward?

Peter Maiorano: Yeah, I think, you know, projections that I’m seeing and reading for deposits over the course of 23 or sort of by the end of 23 are in sort of the 2.3-ish  trillion range. So maybe a slight, slight reduction but not material. And as you’re saying, I think most of the trade off, if you will, and the money funds, willingness to extend is going to come out of the RRP itself, not as much out of deposits.

Bipan Rai: Hey, I mean, remember back in 2019, I believe it was, the end of the last Fed rate hike cycle. We did see a spike in repo rates back then. If I recall correctly, the concern back then was the fact that there was really a lack of certainty or maybe banks were a little bit overly optimistic in terms of what they saw as the minimum level of reserves in the banking system. Do you see a similar risk this time around as well as we continue to push forward with QT and a whole host of other factors that are worth eyeing into next year?

Peter Miorano: Yeah, that’s a great question. Yeah, the repo spike as it’s referred to as in September of 2019, did come at sort of the tail end of the QT and the Fed reducing its balance sheet at that time. But I do believe there were a couple of significant changes. First and foremost, the Fed has put in place the SRF, the Standing Repo Facility, which should go a long way to supplying liquidity to the markets in times of stress and I would think greatly reduce the chances of such a repeat. And I think it’s put in place though, for the exact reason that we’re discussing here, that the Fed could overshoot on its balance sheet reduction and liquidity could become an issue. But I do think that having that program in place mitigates that risk quite a bit. That, as I said, first and foremost, is there to be able to combat that. But also there were sort of a confluence of events that took place in September 2019 that that all led to where we got. I think you had a lot of levered players in the market who had gotten very, very used to relying on very short term funding, a lot of overnight repo funding. You had a lot of smaller, lightly capitalized broker dealers in the market who were trading huge repo books and funding themselves on an overnight basis. And those smaller broker dealers don’t have access to the money market funds, they don’t have the ratings to be able to deal with them. So they were in large part reliant solely on funding on the repo broker screens. And when larger banks were not able to disintermediate that market because they had September 30 quarter end balance sheet limitations. So it really was sort of a confluence of events that led to that sort of anomaly, I would say, in the market. And I don’t believe and never say never, but I don’t believe that thing should happen again given the changes that are in place since then.

Bipan Rai: Right. So it sounds like you’re really optimistic about QT going forward into next year and not causing a hiccup in the repo rate market similar to what it did in 2019 then, if I’m hearing that, right? Correct, Pete?

Peter Maiorano: Yeah, absolutely.

Bipan Rai: Yeah. Now, with respect to quantitative tightening, do you envision that proceeding smoothly as it has been so far up until the end of 2023, or do you think there are bound to be some hiccups along the road, maybe not directly related to the repo market?

Peter Maiorano: Yeah, You know, I mean, at this point, as far as I can see or tell, I don’t see anything that’s going to dissuade the Fed from continuing on the path that they’re on with QT. As I mentioned, you know, I think we’re looking at another over the course of 23, you know, roughly $1,000,000,000,000 of QT occurring over the course of the year. I think the Fed will, you know, they’ll pause and or halt raising interest rates before they alter the amount of quantitative tightening that they’re doing.

Bipan Rai: And what are the big risks to your base case view here, Pete? I mean, what are the sort of black swan like events that could really impact the way you’re looking at things right now?

Peter Maiorano: Yeah, I guess, you know, I mean, from the general market standpoint, if the rate increases end up causing a major recession, you know, and you see a large pivot by the Fed, you know, and the Fed starts easing or has to ease dramatically, again, we’re talking about the Black Swan event in my mind. And I don’t personally see any lowering of interest rate in 2023, although some of the market are calling for that. You could see the Fed sees quantitative tightening, I suppose, in that type of scenario. But even if you know from a standpoint of just bringing it back to the RRP and the levels in the RRP, you know, if that were to happen, you could see the money market funds extending at a faster pace and the levels in the RRP, you know, drop because of that. So I don’t see any event that is going to sort of roil the funding markets, if that’s what we’re talking about.

Bipan Rai: All right. Thanks. I mean, these are interesting takes for everyone that might not be familiar with this market. And certainly it’s going to potentially play a factor as we head into next year and really several additional quarters of the Fed’s quantitative tightening ahead of us. I will say and then close this out with some comments on the dollar, there are a couple of risk events that could end up mattering next year. One of which is going to be the potential looming showdown between Congress and president when it comes to the debt ceiling. And that’s something that does merit watching, at least from a liability standpoint when we look at the Fed’s balance sheet potentially. We’ve written a little bit about this already, and we will be following up on this in early January. But suffice to say that if we do see transition in terms of the liability side of the Fed’s balance sheet away from the Treasury general account and to a build in, say, bank reserves, that could pretend to some US dollar downside. And that’s one of the key reasons that we remain somewhat bearish to the US dollar into next year. So I’ll close out this episode of The FX Factor by thanking you, Pete, for joining us, and we’ll certainly have you back on next time.

Peter Maiorano: Thank you very much, Bipan. It’s been great to spend some time with you. Thanks.

Bipan Rai: Excellent. And thank you all for listening in. We’ll be back early next year with an additional round of new episodes. Looking forward to it. Have a safe and happy holiday and wish you all a happy 2023. Cheers.

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