A CRACKING CREDIT PUMP IS LOSING LIQUIDITY!: A SOFR Alert

I warned this summer, when I first wrote about how Bidenomics was using the BTFP and Reverse Repos (RRP) to create stealth liquidity (in terms of facilitating the US Treasuries using short term T-Bills to inject a steady stream of cash into the financial system), that this would come to an end by year end. It appears that is what is about to happen.

RRP DROPS FROM ~2.5T to only ~$768B

The Fed’s Overnight Reverse Repo tumbled well below $800 billion for the first time since June 2021 amid a growing debate of where and when the Fed’s reserve scarcity constraint will be hit. We warned that liquidity is rapidly approaching the reverse repo constraint level, which could emerge as soon as the RRP facility dropped to somewhere in the area of $700 billion, at which point the market’s all-important credit plumbing would start to crack.

Reverse repo plunged recently by $65B in one day, in one of the biggest liquidity injections in RRP history, also fast approaching the $700BN reverse repo liquidity constraint level.

The problem is the all-important Secured Overnight Financial Rate (the SOFR Rate is the new LIBOR) has jumped to ~5.39%, the highest on record (chart right).

This significantly increases the spread between the SOFR and Overnight RRP rate (chart below).

According to experts:

 “the move is consistent with the slow theme of less cash & more collateral in the system” – (i.e., growing reserve scarcity) – and “may have been exacerbated by elevated dealer inventories, bi-lateral borrowing need, and limited excess cash to backstop repo. If funding pressure persists, it risks Fed re-assessment of ample banking system reserves & potential early end to QT.”

THE “SKINNY” ON THE PROBLEM

Extracted and Annotated from FX Hedge

Turn the clock back to early 2021 and the Fed was desperate to continue creating trillions of dollars for the Treasury to spend but minimize inflation.

Purposely letting the reverse repo facility go wild was their answer. The Fed purchased Treasuries, using money it created digitally. That reduced the supply of Treasuries available and drove their yields to near zero. As the Treasury spent all the money it borrowed, that money worked its way into the banking system, where it would multiply. When the Fed creates a dollar for the Treasury to spend, it’s only about 10% or so of the total amount of money created, because fractional reserve banking multiplies the initial dollar into a total of about 10. So, if you can short circuit this part of the process, you neutralize 90% of the inflation. That’s what happens with reverse repos. The Fed “borrows” money and sits on it, preventing it from being lent out and multiplying. It’s the same as when the Fed pays interest on reserves, paying banks to park their money in its vaults and not lend it out.

Just how extensive was this practice? Earlier this year, the Fed was paying over $800 million in daily interest to “sterilize” $6 trillion through its reverse repo facility and interest on reserve policy combined. Let that money out to play, and it’ll quickly turn into about $60 trillion – then you’ll see some REAL inflation. Now we can understand reverse repos as not just a cause but a symptom. The facility’s usage ramps up when there is too much liquidity and interest rates are going to break through the Fed’s floor.

So, why have reverse repos come down so much from their peak earlier in the year of $2.8 trillion to < $800? Because supply and demand are coming back into balance.

1. The Fed selling securities is reducing the supply of loanable funds.
2. The Treasury’s borrowing spree is jacking up the demand side.
3. The excess supply is coming down.

This means the Fed’s arbitrary interest rates are becoming more realistic for today’s market conditions. (We say more realistic but maybe we should say less unrealistic.) As the Treasury creates more demand, the Fed doesn’t need to artificially create it, so reverse repos are falling. People are just lending to the Treasury instead of lending to the Fed. This is exactly what MATASII identified this summer

Now, what happens if the Treasury keeps borrowing while the Fed keeps selling securities? Demand would eventually exceed supply as reverse repos go to zero, and we’d be out of equilibrium. Then the whole financial world implodes. At least that’s what newly self-appointed experts think. In reality, all that would happen is financial institutions would start using the repo facility, as opposed to the reverse repo facility. Now, instead of loaning money to the Fed, they’d be borrowing it.

Why would a bank borrow from the Fed in this instance? Because they can get a higher interest rate somewhere else, like a Treasury auction. Remember that this is a large merry-go-round of debt. People are increasingly loaning to the Treasury instead of to the Fed today. When reverse repos run dry and we tap repos, people will be borrowing from the Fed to loan to the Treasury. As the Treasury continues sucking all the air out of the room with its multi-trillion-dollar borrowing spree, it has to crowd out more private investment by offering higher and higher yields. That’ll force interest rates higher – too high for the Fed, which has its own interest rate target range it’s trying to maintain.

To prevent Treasury yields from getting too high, the Fed will finance the deficit, using third parties as middlemen who earn interest based on the arbitrage between Treasury yields and the rate on repos. The Standing Repo Facility (SRF) was established in July 2021 to keep a watchful eye on the market and to make sure rates don’t go too high above the Fed’s target, like they did in late 2019. When overnight rates exploded above the Fed’s target, they quickly sold securities to increase the supply of loanable funds and bring rates back down to within their target range. You can expect them to step in again when reverse repos run dry, and the Treasury demands more money. While this isn’t Armageddon, it isn’t good either. By keeping rates artificially low and using repos to conduct stealth quantitative easing, the Fed is going to put us right back on the inflation roller coaster.

We also forget that before the March 2021 surge, reverse repo usage between $200-300 billion was the norm, not $2 trillion. And before the introduction of ZIRP (zero interest rate policy), it was $20-40 billion. The idea that financial markets will collapse if reverse repos return to normal levels is silly. What’s much more dangerous—and will happen at the same time—is the Treasury sucking all the air out of the room. By drawing so much investment out of the private sector, capital will only get scarcer, and the least profitable companies will be the first that are unable to maintain financing, and therefore operations. That’s when countless “zombie” companies will go under, and layoffs will become much more common.