AFMC - Stocks And The Reverse-Repo Reaper
2024-01-17 09:52:00 ET
Summary
- Liquidity is the lifeblood of capital markets, and in recent years, a quenching supply has come from the Federal Reserve’s Reverse Repo Program.
- Repurchase agreements are essentially short-term loans that allow financial firms to borrow from each other by posting low-risk securities as collateral.
- By our estimate, U.S. liquidity effectively expanded by $300 billion during 2023.
By Raheel Siddiqui
The size of the Fed’s Reverse Repurchase Program has been in serious decline. Such a reduction in liquidity, we fear, could be a drag on equities in 2024.
Liquidity is the lifeblood of capital markets, and in recent years, a quenching supply has come from the Federal Reserve’s Reverse Repo Program (RRP). However, we believe the RRP’s current rate of decline could reduce liquidity and become a drag on U.S. equity markets.
Repurchase agreements—or repos—are essentially short-term loans that allow financial firms to borrow from each other by posting low-risk securities as collateral. Lenders earn a return on idle cash while borrowers get access to capital to finance daily transactions.
The Fed uses repos to control the supply of banking reserves and manage interest rates. In a repo agreement, the Fed might buy Treasury bonds from a bank and sell them back (at a slightly higher price) a week later, thereby injecting reserves into the financial system; in a “reverse repo,” the Fed would sell Treasuries for cash, draining cash reserves. Reverse repos help keep a band on interest rates because banks know they’ll borrow at no less than the predetermined repo rate and receive no more than the rate offered on their reserves held at the Fed.
The RRP grew during the COVID pandemic—peaking at nearly $2.5 trillion2 in December 2021—as the Fed sought to control liquidity being pumped into the system. Then came the Fed’s war on inflation and quest to shrink its balance sheet. Still, liquidity stayed strong—partly because the Treasury, after the debt-ceiling clash, has been replenishing its general account (TGA) by drawing down the RRP instead of sourcing funds from bank reserves.
As a result, while the Fed’s tightening campaign and TGA build-up could have drained $1.44 trillion from the banking system, the RRP drawdown helped finance the Treasury without pressuring bank reserves. By our estimate, U.S. liquidity effectively expanded by $300 billion during 2023. 1
We see challenges from here, however. The RRP has since fallen to roughly $680 billion 2 —down 73% from its peak—and could be fully drawn by the end of 1Q 2024. At that point, the government may have to finance itself by issuing coupon-bearing debt, which could drain further reserves from the banking system.
If not accompanied by anticipated rate cuts, we fear this systemic liquidity reduction could subdue equity returns in 2024.
For broader perspective on the new year in equities, please see our 1Q 2024 Equity Outlook .
Sources: 1) Neuberger Berman Research, FactSet; data as of December 15, 2023; 2) Federal Reserve Bank of New York.
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Stocks And The Reverse-Repo Reaper