At the close of the third quarter yesterday, the Fed’s reverse repo holdings hit another all-time-high.
Virtually no mainstream media is talking about this, because it’s kind of a complicated concept. But, it could have some important implications for the markets once the Fed gets around to tapering.
So, let’s try to wrap our heads around this normally unimportant and arcane Fed function.
What are reverse repos?
Repo here is short for repurchase; so a “repo contract” is when you agree to buy back something. Simple.
A reverse repo contract is when you sell a security with the agreement to buy it back at a certain price at a certain time. Why would you want to do that? Well, it’s basically a way of turning a futures contract into a short-term collateralized loan.
It’s really popular to do this with treasuries. Basically, it allows a bank to borrow money on its bond holdings. They do this with other banks, but the key here is that they also do it with the Fed.
Banks can “reverse repo” treasuries to the Fed in order to get cash, and the Fed can “reverse repo” to the banks so that banks and put their cash holdings in a “safe” place.
You can see how this is connected to QE
The Fed buys treasuries from the market as part of its quantitative easing program.
The idea is that by buying up bonds, they are putting cash into the financial system. Then that cash will be used to buy things and support the markets and the economy. It’s especially important for ensuring there is enough liquidity.
But, when banks have more than enough liquidity, they “give it back” to the Fed in the form of reverse repos. So, if the Fed’s reverse repo holdings are increasing, it means that there is more money in the market than the market is willing to spend.
The actual mechanics
So, in QE, the Fed buys bonds in order to provide cash to the markets. But, if the markets don’t have anything they want to buy, they put that money in the bank.
The bank is penalized for holding cash for too long. So, they go to the Fed, and use a reverse repo mechanism to “buy” bonds back.
In other words, if the amount of reverse repo holdings that the Fed has is increasing, while they are doing a QE program, it means the money is kind of just going through a circle and ending up back at the Fed. Or, the QE program isn’t having (as much of) an effect on the markets.
What does this mean for stocks?
The higher amounts of liquidity from a QE program are understood to help push stocks higher. But, if that liquidity is just going back to the Fed, then the impact is reduced.
If the Fed starts to taper, then the banks can still access the same amount of liquidity by simply not doing repos. Currently, the Fed holds over $1.6T in reverse repos.
Normally, that amount is just in the few billions, as banks are just using it to balance their books at the end of each day.
The implication is that there is a massive amount of “latent” liquidity that would be available to the markets even if the Fed starts its taper. This is because a substantial portion of the money injected through QE is just sitting in the bank.
