The Fed’s reverse repo facility hit US$197.8 billion on December 31, 2013, the last day of the quarter and year. While some increase was expected due to dealer pullback in the repo markets at quarter and year end, this almost US$200 billion is a pretty high figure. Is this the start of a longer-term trend and at what intervals? Let’s take a look at the evidence on the table then turn to speculation about the future.
First, the end of year spike in the Fed’s accepted reverse repo bids was by far the largest on record since the pilot program got started in September. Not only that, but 102 bidders participated; we would guess that this was almost all the money market funds on the Fed’s list plus some of the GSEs and banks for good measure.
By Friday outstanding volumes had declined to US$56.7 billion, almost a quarter of end-of-year volumes but still a healthy sum.
Second, as we noted in our November 2013 research report, “The Federal Reserve, Reverse Repo, Collateral and Benchmarking,” this is a risk vs. return question. Money market and cash collateral investors have long turned to other markets at quarter end when overnight treasury repo got scarce, but now they have an opportunity to capture a very low risk (and low return) investment if they want it. And apparently they do want it. Hence, we conclude that the interests of conservative money market investors (and not just money market mutual funds) lean towards the lowest risk with less concern for generating the higher returns available in other products.
Third, the Fed recently increased the borrow limit from US$1 billion to US $3 billion. This opens up more avenues for bigger players with substantial cash inventory to establish positions. Speaking to the WSJ last week, Lou Crandall at Wrightson ICAP said that “As part of their testing, Fed officials ‘wanted to see what kind of take up they’d have during year-end markets.'” We add that there wasn’t really any question about what would happen, only by how much.
Fourth, reduced treasury bill issuance may have limited other opportunities for money fund investors, leaving approved counterparties turning to the Fed’s repo as an alternative investment solution for that part of their portfolio. In a Bloomberg article last week, Kenneth Silliman, head of U.S. short-term rates trading at Toronto-Dominion Bank’s TD Securities unit in New York, said “The reduction in bill supply that has occurred in recent months is also having an effect, triggering money-market funds to use the Fed’s program as an investment alternative.”
With all this known, let’s turn to the speculation: will this US$200 billion level of repo with the Fed be the new normal or is it just a quarter end phenomenon as dealers pull back to clean up their balance sheets? We’re pretty sure that the quarter end spikes will continue and may move to month spikes as dealers need to respond to LCR and other risk capital requirements. That said, we see two other factors that could push more repo with the Fed on a daily basis:
– If dealers start looking at daily averages and not month or quarter ends. In this case repo dealers will likely reduce their overall activity, precipitating a broader restructuring in the repo markets in general. This would reduce dealer overnight treasury supply for cash providers on a structural basis and drive cash towards the Fed for overnight treasury repo.
– If cash providers get comfortable with the Fed over dealers. This could be operational or reputation-based reasons (look how low our counterparty risk metrics are!). Money market funds and securities lending cash collateral investors have, we think, already gotten comfortable with awful repo returns anyhow, so who cares if the rate of return is 3 bps or 8 bps? Maybe not cash investors who just want repo as a safe place to put cash overnight.
We expect there will be more debate on this topic for some time to come. We have already put the topic on the agenda for the Finadium 2014 Conference in NYC.