Is the Fed reversing course after all?

Legendary US journalist Edward R. Murrow may be best known for the line which he used to end his broadcasts – “Good night, and good luck” – but this column’s favourite comment of his goes “Anyone who isn’t confused really doesn’t understand the situation.”

Well, there is one particularly confusing situation out there in the narrow world of financial markets right now, and that is the US overnight (reverse) repo market. This may sound esoteric, but it is not, because a reverse repo is the direct opposite of quantitative easing (QE), in that it drains cash from the banking system, and the US Federal Reserve is using reverse repos in vast quantities even as it continues to run QE at $120 billion a month.

US Federal Reserve assets now exceed $8 trillion

Source: FRED – St. Louis Federal Reserve

“The US Federal Reserve is using reverse repos in vast quantities to drain liquidity from markets and the US financial system even as it continues to run QE at $120 billion a month.”

That programme means the US central bank’s asset base now exceeds $8 trillion, or more than a third of US GDP, for the first time ever. But as fast as the Fed is pumping liquidity into the system with one hand, it is taking it away with another.

Confused? You should be.

Repo man

By way of a reminder…

• A repo (or repurchase agreement) sees a financial institution sell Government bonds (in this case US Treasuries) to another one, either a bank or central bank, on an overnight basis. It then buys them back the next day, usually as a slightly higher price. The idea is the seller can raise immediate liquidity if they happen to need it. (It also enables the counterparty to make a financial return pretty much without risk, given the extremely short time horizon involved and the collateral that backs the trades.)
  
  Regular readers will remember how the repo rate spiked suddenly in the US in autumn 2019 in what was seen as a sign that the Fed’s then quantitative tightening (QT) plan (of raising rates and withdrawing QE) was working well – so well that banks were scrambling for cash as the financial system began to creak. Under Jay Powell, the US central bank backtracked on QT and – as the pandemic hit – cranked up QE to ever-more dizzying levels in 2020. That tidal wave of liquidity means the US overnight repo rate is 0.07% – down from that panicky 6.9% one-day spike two Septembers ago.

US repo rates spiked in 2019 but have ground ever lower since

Source: Refinitiv data

• In a reverse repo (or reverse repurchase agreement) a bank or central bank sells Government bonds in exchange for cash to a range of counterparties, over a predetermined timeframe (often overnight). This therefore drains cash out of the financial system, at least if a central bank is doing it, and the Federal Reserve is hard at work here right now. At the last count, the Fed’s outstanding reverse repo liabilities were $791 billion, the equivalent to six a half months of QE.

“At the last count, the Fed’s outstanding reverse repo liabilities were $791 billion, the equivalent to six a half months of QE.”

Fed reverse repo deals have spiked in the past three months

Source: FRED – St. Louis Federal Reserve

Policy shift

Perhaps the US Federal Reserve is laying the groundwork for tightening monetary policy after all and taking these initial steps to test how financial markets (and the economy) will react. The answer appears to be ‘so far, so good’ on both counts. The S&P 500 trades at record highs while there is no sign of financial stress anywhere in the system, at least according to the tried-and-tested St. Louis Fed Financial Stress and Chicago Fed National Financial Conditions indices. Both are trading very close to their all-time lows.

US economy is showing no signs of financial stress at all

Source: FRED – St. Louis Federal Reserve

“This initial foray into tightening policy could be seen by Fed officials as a success since neither financial markets nor the economy appear to be wavering. But any business model or asset valuation that is being goosed by zero-interest-rate policies (ZIRP) and QE will face bigger tests if the Fed really is going to surprise the markets and tighten monetary policy, no matter how gently.”

This has several potential implications.

• As US equity markets trade at all-time highs, American unemployment ticks lower, wage growth reaches 5.7% on an annualised basis and US house prices rise at the fastest rate in nearly 30 years, perhaps the Fed is getting nervous that there is too much cheap liquidity around.
• This initial foray into tightening policy could be seen by Fed officials as a success since neither financial markets nor the economy appear to be wavering. This is in stark contrast to autumn 2019’s repo rate spike, as that was when WeWork’s much-hyped flotation fell apart, bitcoin sank 25% in a month and wider equity and bond markets both got the jitters, albeit very briefly. It would surely be a good thing if financial markets could break their addiction to cheap Fed liquidity.
• Any business model or asset valuation that is being goosed by zero-interest-rate policies (ZIRP) and QE will face bigger tests if the Fed really is going to surprise the markets and tighten monetary policy, no matter how gently. This ranges from loss-making so-called unicorns and equity ‘growth’ stocks to private equity firms which are feasting off cheap money to make acquisitions.
• In theory, tighter money could have negative implications for gold and other ‘real’ assets. Equally, a fresh backtracking by the Fed and an end to the reverse repo scheme, while QE keeps running at $120 billion a month, could stoke fresh interest in precious metals and other perceived stores of value. Gold did well when investors felt central banks were losing control (2007–11 and 2019–20) and less well when they took the view the authorities had matters in hand (2012–18 and 2021).

Past performance is not a guide to future performance and some investments need to be held for the long term.