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Reverse Repos EXPLODE! Is This Signaling Next Economic Collapse?


Reverse Repos EXPLODE!

Overnight Reverse Repurchase Agreements by the Federal Reserve have skyrocketed in recent weeks. The highest daily amount on record spiked to over $900 billion a day on June 30th, 2021. These numbers are unprecedented in the overnight reverse repo market!

Talking heads in the mainstream media have downplayed these unprecedented levels as there being too much liquidity in the market.

But as George discusses in this video, there might be something more ominous going on in the reverse repo market that the money market funds have caught onto.

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The concern now is whether this is signaling another economic collapse or not.

To figure this out, let’s first look at how the dollar moves around between the commercial banking system and the Fed.

U.S. Dollar Flows

As we know now, all dollars are liabilities of a bank. Dollars of private citizens are liabilities of the commercial banking system while commercial bank dollars are liabilities of the Federal Reserve.

When the Fed creates dollars, or bank reserves of the commercial banks, it creates additional lending capacity.

Commercial banks use this lending capacity to create loans. In doing so, banks create potential inflation by increasing the number of dollars chasing the same amount of goods and services in the real economy.

The Federal Reserve has multiple accounts including reserve accounts for commercial banks as well as the reverse repo account.

When sources of capital, like money market funds, decide where to park their money, they might choose between the Fed’s reverse repo account and a commercial bank where their money will end up in a reserve account.

If money market funds park their dollars in the FED’s reverse repo account, they are paid 5 basis points. Whereas the Fed pays 15 basis points to hold dollars in reserve accounts.

According to the Fed website, reserve balances have gone down in recent weeks. If this is the case, why are we seeing so many dollars going to the reverse repo account where they earn a lower interest rate?

The most popular answer is that these entities want pristine collateral, namely T-Bills. This may be the case. However, what are money market managers and other capital sources fleeing from at the banks?

Counterparty Risk

It appears that money market managers have decided to take some risk off the table by parking their money at the Fed because of counterparty risks with the banks.

Additional income from stimulus checks and government spending have been propping up the economy since the start of the Cerveza sickness. Without these payments to the private sector, we probably would have seen a huge deflationary bust in asset prices. Namely the stock market and housing market.

Like it or not, the party is slowly coming to an end and Americans are beginning to have to pay for their stuff again.

The federal mortgage payment forbearance recently ended on June 30th. This allowed people impacted by the pandemic to hold off on making their mortgage payments.

Also, the additional federal unemployment benefits ended early in many states. Currently, 25 states and counting have ended the federal program early and Biden has indicated he will not extend them past early September.

Finally, the CDC mandated eviction moratorium will come to an end on July 31. It is estimated that between 5.7 million and 7 million Americans owe back rent.

These programs have led to an increase in income for Americans and a subsequent increase in consumer spending. At the same time, we have seen a decrease in expenses. This combination has led to a temporary increase in purchasing power.

As all of this comes to an end, and if the money market managers are aware of these counterparty risks, it would make sense to park money at the Fed where it is insulated from these risks.

Money market funds provide liquidity to hedge funds and other entities in exchange for collateral in the normal repo market. This collateral is typically a combination of different assets like T-Bills or Mortgage-Backed Securities.

But if the risk profile of these assets increases due to these counterparty risks, the money market managers will ask for higher quality collateral in exchange for the dollars they provide. This increase in the demand for pristine collateral could be the reason why there has been an increase in the reverse repo market with the Fed.

Is this Signaling Next Economic Collapse?

An increase in the risk profile of these collateralized assets means there is greater risk in the banking system. And when there is more risk in the banking system, there is an increased probability of an economic collapse in the stock and housing markets.

In September 2019, repo rates spiked to 10%. Most commentators attributed this spike in the repo rates to a shortage in the supply of cash available in the system. Others have hypothesized there was a shortage in the amount of pristine collateral available.

Although repo rates are not spiking as they did in 2019, it looks like we may have another shortage of pristine collateral.

The bottom line is there are similar risks in the market now and the unprecedented recent levels of reverse repo agreements have only increased the probability of another crisis in the stock and housing markets in the future.