Market Pulse: The Federal Reserve's 2 Trillion Dollar Hole
Market Pulse: The Federal Reserve's 2 Trillion Dollar Hole
In 7 minutes, understand what the Fed’s ON RRP balance is, why it dropped by $2 trillion in 8 months, and why this matters for stock prices.
✅⚡ In 7 minutes, understand what the Federal Reserve’s Overnight Reverse Repo facility is, why it dropped by $2 trillion in 8 months, and why this matters for stock prices.
The Overnight Reverse Repo facility is a key Federal Reserve tool that’s used to stabilize interest rates.
Ominously, $2 trillion has been sucked out of the facility since May 2023. That’s “trillion” with a T!
In this newsletter issue, let’s go over what the Overnight Reverse Repo facility is, why its balance fell by so much, and why this is ultimately good for the stock market.
💡 What Is the Overnight Reverse Repo (On RRP) Facility?
ON RRP allows non-bank institutions like Money Market Funds (MMFs) to lend cash to the Fed and earn interest.
The loan duration is short, 24 hours, but it can be refreshed everyday.
The interest earned is set by the Fed and is currently 5.30% annualized.
The Fed uses the ON RRP to control interest rates in the economy. In other words, if the Fed wants the economy’s risk-free interest rate to be 5.30%, the ON RRP is one of the tools it uses to keep it there.
Because of the vast amount of money that’s parked at the ON RRP, it has a profound effect on the stock market.
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💡 Why Did the ON RRP Get $2 Trillion in 2021?
The ON RRP balance started climbing from $0 to over $2.4 trillion in early 2021.
This was around the same time when the Fed started raising interest rates in March 2021 and there is certainly some causation here.
The main culprit behind the rising ON RRP balance is Money Market Funds (MMFs, remember this acronym). MMFs grew to become a massive industry over the past decade with over $4 trillion in funds parked in them.
MMFs can only invest in short-term debt that matures within 397 days. As such, one of their favorite debt instruments to invest in is short-term US government bonds (aka Treasury bills).
However, the value of Treasury bills falls when interest rates rise and this makes Treasury bills a bad investment for MMFs.
This is because MMFs need to be highly liquid.
Customers expect to be able to withdraw money from an MMF at any time. If the Treasury bills on an MMF’s balance sheet are losing value, and there are large customer redemptions, then the fund could be forced to sell at a loss.
As a side note, Treasury bills could appreciate or depreciate during their lifetime but will always pay back the full principle and interest at maturity.
Selling too many assets at a loss could eventually crash a fund. MMFs want to avoid this as much as possible.
As such, as interest rates rose and Treasury bills fell in value, MMFs directed trillions of dollars to the Fed’s ON RRP rather than Treasury bills.
Because ON RRP doesn’t lose value as interest rates rise since they’re a short overnight loan that’s guaranteed by the Fed, MMFs consider it a safe investment in a rising interest rates environment.
💡 Why Did the ON RRP Lose $2 Trillion in 2023?
The ON RRP balance started falling in May 2023 when the Fed stopped raising interest rates and the US government’s debt ceiling was lifted.
This had two primary effects that made Treasury bills an attractive investment for MMFs again:
First, after the debt ceiling was lifted, the US Treasury started flooding the market with Treasury bills to raise money.
Second, with interest rates plateauing and possibly even falling, Treasury bills are less likely to fall in value and might even appreciate if interest rates fall.
As such, MMFs started redirecting cash away from the ON RRP into Treasury bills and here we are, 8 months from May and the ON RRP is down $2 trillion.
💡 This Is Good for Stocks, Why?
The ON RRP sucks liquidity from the economy.
Cash in the ON RRP is cash parked at the Fed and not doing anything. This cash could instead be used in the economy for capital investments or buying stocks.
As such, diverting cash away from the ON RRP is ultimately better for the stock market and the economy. That is, unless it triggers more inflation!
This is why it’s a good thing that the ON RRP balance fell by $2 trillion since May. That’s $2 trillion that was returned to the economy.
In addition, because this newly available cash was largely used to buy Treasury bills (aka funding the US government’s deficit), when the ON RRP balance runs dry, the US government could run into serious funding issues and the Fed is forced to intervene by easing financial conditions to buy US government debt.
If the Fed doesn’t intervene, short-term interest rates could sky rocket when there are too few buyers for US government debt. Next year, a record high of $8 trillion in US debt needs to be refinanced and the US government seriously needs a bid for new debt issued next year.
Turns out, an easing of financial conditions is exactly what the Fed is signalling.
At the current rate of ON RRP depletion, it’ll likely run out sometime in March.
This is why Dallas Fed President Lorie Logan said last Saturday that the Fed is considering reducing Quantitative Tightening when the ON RRP runs out.
In layperson’s terms, this means the Fed will ramp up money printing again to buy more US government debt.
Money printing is good for stocks.
💡 Putting This Into Practice: Ides of March
With the ON RRP on track to deplete by March, all eyes are on the Fed’s actions in the March FOMC meeting.
If the Fed doesn’t do anything, the market will likely sell-off given the high risk of greater interest rate volatility as MMFs, a major buyer of US government debt, disappears from the market (all their spare cash from ON RRP depletion have been used up).
If the Fed does decide to print more money to buy US government debt, the market will likely rally on easing financial conditions.
As such, March will be a volatile month (risk to the downside) as market anxiety rises on uncertainty around what the Fed does at the March FOMC meeting (March 22nd).
It’s best to pare back on portfolio risk during this month.
In addition, the Fed is expected to start cutting interest rates at this FOMC meeting and all recent recessions have started shortly after the Fed’s first rate cut. It’s an ominous trend that exacerbates market anxiety.
The Ides of March marks the anniversary of the notorious assassination of Julius Caesar and subsequently became an annual deadline for settling debts in the Roman Empire (cue “how often do men think about the Roman Empire?” questions).
Beware the Ides of March. It’s a fitting analogy for the stock market this March.
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