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Observations On Reverse Repos Coupled With A Record Excess Bank Reserve Balance

Tyler Durden's picture


Those who follow the meandering permutations of the Fed's balance sheet must have observed with great irony the proclamation by the NY Fed on October 19th that it is prepared to commence tightening liquidity via reverse repo operations, even as 48 short hours later later the Fed announced a new all time high in bank reserves, which for the first time ever hit a level over $1 trillion. The glaring discrepancy between these two observations has left many wondering not only about the veracity of any statements coming out of the Fed, but to consider what the best trades to front-run the Federal Reserve may be for that time when, whether it likes it or not, the NY Fed is forced (politically or otherwise) to start extracting its pound of flesh from the banking system.

The chart below demonstrates the dramatic pick up in excess reserves, which after lying relatively dormant around the $800 billion level, have shot up by over $200 billion in less than two months.

What is particularly notable is that the excess reserves hit a record level hours after rumors swirled that the Fed's reverse repo test conducted this Monday was a failure, and that instead of attempting to interact with banking institutions in a test attempt to raise $200 billion in liquidity, the Fed was forced to approach money market funds instead. Indeed, as Dow Jones reported, money market activity for the latest week would confirm speculation about major MM outflows, with $41 billion withdrawn from such funds, even as MM levels have continued to decline persistently, and hit a recent low of $3.339 trillion. With a 20 bps risk-free arb courtesy of the Fed deriving from MM record low rates at 0.05%, while the target fed-fund rate is at 0.25%, it is no surprise that capital will continue to flow toward the Federal Reserve.

It would probably require Sheila Bair to come out with another YouTube video in which she placates fears that money market investors are now collateralized by precisely the same toxic MBS garbage that banks, domestic investors, China and, most recently, Pimco have all decided to prudently keep far away from.

Not surprisingly, the primary source for bank reserve expansion continues to be the Fed's ongoing monetization of Treasurys and MBS. And even as the first is winding down, the second still has around $400 billion in dry powder left. Add to that the nearly $200 billion in additional liquidity that is forthcoming courtesy of the wind down of the Supplemental Financing Program, which is the Fed's latest "two birds with one stone" program of keeping the US debt ceiling from being breached, and allowing banks to purchase yet more risky assets, and Americans are easily looking at an excess reserve balance well north of $1.5 trillion within 3-6 months: money that should be lent out, but isn't. After all why take risks when you can make risk free money courtesy of the US taxpayer (the interest the Fed pays on the reserves comes straight out of the taxes Americans pay. Damn it feels good to subsidize Wall Street's kleptocracy class with every biweekly federal tax withholding). As for the party line, here is what the Fed says about funding excess reserves:

Why is the payment of interest on reserve balances, and on
excess balances in particular, especially important under current conditions?

Recently the Desk has encountered difficulty achieving the operating target
for the federal funds rate set by the FOMC, because the expansion of the Federal
Reserve’s various liquidity facilities has caused a large increase in
excess balances. The expansion of excess reserves in turn has placed
extraordinary downward pressure on the overnight federal funds rate. Paying
interest on excess reserves will better enable the Desk to achieve the target
for the federal funds rate, even if further use of Federal Reserve liquidity
facilities, such as the recently announced increases in the amounts being offered
through the Term Auction Facility, results in higher levels of excess balances.

It is sad that the only way to keep deflation in check is to effectuate this kind of wealth transfer out of America's working class into the kleptocratic oligarchy. 

Yet perhaps the reverse repo approach will at some point prove successful (even if it did not this past Monday). Here is what market participants read between the lines from the NY Fed's October 19th reverse repo announcement:

1. Ensuring reverse repos will be ready when and if the FOMC decides to use it
2. Possibly expanding the set of counterparties in reverse repos
3. Expanding reverse repos to ‘triparty’ settlements

While the statement is traditionally broad and non-committal, Morgan Stanley does highlight one aspect of it:

We stress that neither did the NY Fed statement confirm that no reverse repurchase operations were in the works before year end, as it again has no capability to make such decisions. This is an important nuance that the market likely missed, which may cause it to misprice the tail risk of a near-term drain.

In other words the Fed may or may not do something or another, depending on what the callers from speed dial 1 through 5 (name your top 5 banks as sorted by declining amount of interest rate swaps in the trillions) instruct Bernanke to do.

An issue meriting further attention is the concept of triparty reverse repos. As Zero Hedge recently pointed out, the NY Fed has been so careless in using these in the past, that in the case of Lehman Brothers it actually used the stocks of numerous bankrupt companies as collateral for the $40 billion triparty repo backing up Lehman's balance sheet in the days after it filed for bankruptcy.

Here is Morgan Stanley's interpretation on what the use of triparty reverse repo will mean:

A tool that the NY Fed may ultimately rely on to drain large quantities of reserves is a triparty reverse repo. This is the least operationally intensive way for the NY Fed to drain large quantities of reserves from a large number of participants (currently only dealers but in time may include GSEs, money market funds & other institutions).


One effect of the Fed’s potential reliance on triparty reverse repos to drain excess reserves is that large quantities of collateral will be made available to the market – so if the Fed decides to drain say $200 billion of excess reserves, approximately $200 billion of extra collateral will be available for GC [General Collateral]. This will cause GC rates to rise, potentially above overnight fed funds or above OIS when speaking of term.

And in case investors would like to gradually step in against prevailing popular thought and take the other side of the Fed trade, on the assumption that at some point the Fed will be forced to stop printing trillions of new dollars, MS shares the following:

The fact that banks are not arbing out the risk-less spread between the overnight fed funds rate and the 0.25% overnight deposit rate at the Fed is another example of an ‘arbitrage’ that is often left on the table (Exhibit 2). In this case, one of the reasons that this spread has not collapsed to zero as banks compete to borrow below the deposit rate and invest it overnight at the Fed at 0.25% from the supply side is because credit line limits may be reached that prevent cash-rich non-bank participants from lending beyond a certain limit to the commercial banks. From the demand side, commercial banks may not want to increase the size of their balance sheet that would be involved in earning this spread. We mention this example in passing only to demonstrate that when and if the triparty repos are done in size , they may disrupt the historical OIS / GC spread relationship and seeming ‘arbitrage’ opportunities may not entirely keep this spread from inverting.

Therefore, if investors are not too comfortable with going short risky assets on the bet of liquidity tightening (the topic of a later post), a levered bet on an OIS-GC spread tightening may be one much less risky approach to play the contra-Fed strategy.

And some additional thoughts on this trade from MS, which believes that the market is certainly not discounting for reverse repos hitting the market any time soon:

Talk of reverse repos has added some uncertainty to the market, but front-end rates have barely budged. Since bottoming out at 0.13% at the start of October, the 6-month US T-Bill rate has remained near its lows at 0.16% (Exhibit 3). Meanwhile, the 3-month US T-Bill rate has not moved at all and GC to the end of the year is now lower than it was at the beginning of the month.


Further, most of the volatility remains further out the curve between the 1s/2s Treasury spread (Exhibit 4 - light blue) and not in the 6m/1y Treasury spread (Exhibit 4 - dark blue). This indicates that the market is no more worried about higher front-end rates in the very front end of the curve than it was at the beginning of 2009 – and continues to be more worried about higher rates / the level of curve further out in time, say in 1-years time.


This implies that investors who believe OIS / GC spreads will tighten can take advantage of current entry levels.


What the market is saying is that not only is the Fed not "in danger" of tightening any time soon, but that its disclosed preferred mechanism of liquidity extraction via reverse repos is not likely to be effectuated any time soon, especially in light of the failed Fed test on Monday. The "don't fight the Fed" ideology has become everyone's bedtime mantra. And as long as the Fed is willing to throw trillions simply for the sake of redefining triple digits P/E multiples as the new "normal," so be it. Madoff also thought he could run his scheme for ever. Either that, or he simply did not think about the consequences of what happens when the status quo changed. The Federal Reserve is now caught squarely in the same position. And, just like Madoff's ponzi scheme imploded with $50 billion disappearing overnight (and no, there was no greater fool to throw the hot potato to), so the same will happen with the US capital markets one day. The event is a certainty, the timing is still unknown - but keep an eye out on such data points as the OIS-GC spread for some early warnings.


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Sat, 10/24/2009 - 14:38 | Link to Comment Cistercian
Cistercian's picture

 The horror...the horror......


Sat, 10/24/2009 - 16:29 | Link to Comment Rollerball
Rollerball's picture


Tue, 10/27/2009 - 00:19 | Link to Comment john bougerel
john bougerel's picture

Got to say, I agree, this is almost a laugh

Sat, 10/24/2009 - 14:43 | Link to Comment Anonymous
Sat, 10/24/2009 - 14:44 | Link to Comment SilverIsKing
SilverIsKing's picture

<screaming at the top of my lungs>



<my indoor voice>

comex default...

Sat, 10/24/2009 - 15:29 | Link to Comment Anonymous
Sat, 10/24/2009 - 15:32 | Link to Comment Anonymous
Sat, 10/24/2009 - 16:16 | Link to Comment max2205
max2205's picture

3 trillion mmf not 3 b. Right?

Sat, 10/24/2009 - 16:25 | Link to Comment Anonymous
Sun, 10/25/2009 - 22:17 | Link to Comment long-shorty
long-shorty's picture

either start making some "global macro" sorts of allocations for your clients, or else find a global macro manager you trust who can help you or who you can refer clients to.

I run a long-short equity fund, but I have a macroeconomist/RIA friend I trust who I try to talk with frequently. I've found myself making all sorts of trades as a "just in-case." long vix calls, long call spreads on the GLD. you get the idea. try to do things for your clients that won't cost a lot but that can give them insurance against a sudden shock.

Sat, 10/24/2009 - 16:32 | Link to Comment Econophile
Econophile's picture

One of the best ever posts on ZH. Great work, Tylers.

Sun, 10/25/2009 - 16:24 | Link to Comment _Biggs_
_Biggs_'s picture

Hear Hear.


Kleptocracy...I love it.

Sat, 10/24/2009 - 16:37 | Link to Comment Anonymous
Sat, 10/24/2009 - 19:52 | Link to Comment Anonymous
Sun, 10/25/2009 - 00:42 | Link to Comment agrotera
agrotera's picture

in case you don't get an answer from Tyler, here is one for you anony:

Hope all your people have zero debt, land to depend on if they need to have a garden and with larger portfolios, land for trees or other productive assets, gold, silver, platinum and cash even though we don't know how it is going to maintain any purchasing power.  If they can, they might also want an account outside of the us for non us cash.  And, if you are willing to trade, maybe you can help them with currencies, and sovereign bonds from non-US governments that you decide may be stronger financial positions than the US, and a few stocks from non-US companies that you think have strength.  But ultimately, everything but cash and hard assets will get crushed if the PPT cant keep up their game.  So, that is why having land, and no debt seems to be essential.

Sun, 10/25/2009 - 22:20 | Link to Comment long-shorty
long-shorty's picture

I think that's horrible advice. People should stop putting excess equity in their homes now, esp. if they have 5% fixed rate mortgages.


Having a fairly significant amount of fixed rate debt as part of one's portfolio is the BEST hedge against hyperinflation.

Sun, 10/25/2009 - 01:29 | Link to Comment Marvin T Martian
Marvin T Martian's picture

what is it that they put in the water that makes midwesterners so earnest? and would it be possible to supply said water to wall st and DC?


you're the polar opposite of my local small-town bank RIA. i pop into his office when i'm in the bank on other business once in a blue moon, acting like a fool, just to pick his brain to guage the party line. i was in there about a month ago, and he basically told me 'television says recession over!'. but he also has that cornered, desperate, mousy look that reveals he's starting to suspect he's been hung out to dry. dunno if they're about to close the branch or what.

starting in 2003, when i dumped all of his parent company's stock and bought commodities, he'd call to warn me that i'm too 'concentrated'. 500% later those calls stopped. now i just confuse him.


how to allocate the salt of the earth's hard-earned nest eggs? whatever you do, hedge. i think options are good for this- far enough OTM to be cheap yet protect against a drastic move (most people would accept a 10-20% drop and would like even more to profit from anything more than that). but it's pretty tricky to go all commodities, least of all 100% gold/silver. few people would understand that and it would look imprudent- you could get sued/banned if things move against you. plus, lately EVERYTHING is moving together, which it'll likely do going down as well (at least initially).


oil companies offer dividends. agricultural investments would likely appeal to earthy midwesterners- again either options on staples like wheat, corn, soy, or an etf like DBA. my personal feeling is that food will not go down in the foreseeable future and should track broad measures of inflation fairly well. when oil was $140 DBA was almost double where it is today. furthermore, a food crisis would dwarf the oil crisis.


if some of your clients are interested in commodities then i would explain to them that companies are subject to the vagaries of mgm't, cash-flow, the mkts, etc and in times of stress the pure commodity (or etf) usually outperforms.


base metals don't do well during depression/deflation. but they do very well during inflation, much better than gold (which hedges not inflation but fiat currency and CB scheme failure risk). but if we get WWIII, and it's something like a traditional large ground war then base metals (iron especially) will do very well and pay nice dividends. every war is a war over resources, and looking at headlines over the past 15 years shows an increasing scramble for resources.  furthermore, my theory is that commodities were kept artificially low during the cold war so they're quite possibly still undervalued.


regarding countries, canada, australia, and brazil are all very good places to do business. canada and australia are well-regulated and well-capitalized. brazil is stunningly rich, yet still very poor. but in nearly every commodity category (incl water and energy independence) brazil is in the top percentile. and their fiscal policy has been relatively (for lat amer) prudent for 100's of years. in my experience brazilian banks are very impressive. but there's not a currency in the world i believe in long-term. or at least until one becomes fractionally backed by metal (most likely silver i think), but don't hold your breath.


if you get them into a gold fund then you're not trying to be a gold stock picker, which is a tough gig. and if it crashes you can point the finger to other the mgm't (i don't say this to skirt responsibility, merely to insulate against the perception that gold is a fringe investment). that said, TRADITIONAL, PRUDENT portfolio theory includes 10-30% in physical metal, and i think that 25% would seem reasonable to anyone with half a brain considering the times we're in. hedge the physical position (at least until prices are well above their cost basis with short-term options or whatever).


if their houses are paid for then you could consider buying put options on SRS or something. and consider hedging mkt positions with dow/s&p puts. i personally like long-dated options very much right now while the VIX is low.


but it's also important to remember that etf's and options  carry varying levels of counterparty risk. and many etf's have hidden expenses and slippage. furthermore, if commodity prices rise to the point of dragging on the economy i expect 'speculators' to be blamed and somewhat restricted, although it's unlikely your clients would be large enough to brush up against possible position limits.


during the real estate bubble it was often said "they ain't makin' any more of it" so prices can't go down. the same is true about commodities. and unlike companies, commodities will never go to zero- and if they fall you can bet the mkt's fell more. just take a look at how they performed as individuals and as a group during the height of the crisis, and more importantly how they popped first and the most coming out of the crash (far before the broad liquidity rally). it's possible that the dow/s&p are in a secular bear and that commodities are in a cyclical bull that has years left. and if we do have a real, full-blown financial crisis and currency problems/possible collapse then gold is the only thing that stands a chance of carrying you through.


i say all this because with each passing day i think that risk is greatly increasing. but risk is invisible until it's too late. if you can get your clients through this mess intact (inflation/deflation adjusted) they'll name their children after you.


most people, when asked about investments, assume that they're idiots. so don't ask your clients about specifics but generalities. EVERYONE has a sort of hunter-gatherer survival instinct and everyone has broad ideas about what would be a good investment idea and what to avoid. so ask them- they might surprise you. and with your input and experience you can give them confidence to do what they're comfortable with. but i think the most important thing of all is to NOT prepare them for last fall's crash- that already happened and the future by definition will be new. but a good, honest (even folksy) meeting with your clients would likely give you both insight and ideas. most of all they will appreciate your concerns- EVERYONE know's we're teetering on the edge, but not everyone knows that there are opportunities to take prudent and potentially lucrative steps NOW.


all of this is the opinion of someone decidedly not an FIA, so the decisions are yours and yours alone. i'm just sharing thoughts here...


thanks for asking sensible questions (why isn't your co already answering them?) and making a small step in restoring my faith in (FIA) humanity.


best of luck...

Sun, 10/25/2009 - 18:14 | Link to Comment jm
jm's picture

What better place to stir it up than zero hedge.  Caveat emptor...

Why not buy preferred shares of big financials, with an offsetting put on the common stock?

Short term treasury paper paired with gold as a hedge on currency risk.

Sat, 10/24/2009 - 16:50 | Link to Comment Anonymous
Sat, 10/24/2009 - 17:05 | Link to Comment agrotera
agrotera's picture

Dear Tyler,

Thank you for noting:

"After all why take risks when you can make risk free money courtesy of the US taxpayer (the interest the Fed pays on the reserves comes straight out of the taxes Americans pay."

Would you please consider posting an article (or a series) detailing exactly how much money the Fed and it's member monopolists have made over the last 10 (or 96) years so that people could really understand the power of the Fed and once and for all DEBUNK THE MYTH OF THE FED'S INDEPENDENCE--and rather, help put a spotlight on the FED cartel's  full sponsorship of all campaigns so indeed NO LEGISLATORS ARE INDEPENDENT OF THE FED.

It made me sick at my soul to read that Sen.'s Corker and Merkley turned traitor and are sponsoring a bill that discredits Rep. Ron Pauls efforts for auditing the fed, and indeed ENDING THE FED.  If the public has details of the real workings of the fed, the game will be over, because at that point, more and more and more citizens will become watchdogs and not allow the criminality that is now currently legalized by the fed brothers's (cartel members) lobby.

Thank you and very best always!


Sat, 10/24/2009 - 18:26 | Link to Comment Pondmaster
Pondmaster's picture

reverse repo failure ? Same as bond sale failure ? No takers !!

Don't worry  the fed squid will suck all the good cash out of our MM's and sooner than believed - distract detract - leaving us with nothing . Then the Fed will be ended . Last great robbery in progress as we ponder its terms and beginnings . REALLY NEED TO WATCH EXACTLY WHAT AND WHEN THEY START THE REpos

Sat, 10/24/2009 - 18:41 | Link to Comment Lionhead
Lionhead's picture

Excellent work; thank you. While the markets short term expectations may not be effected, the long end may not go along for the ride as the never ending, and out of control spending by the government goes on. The bond vigilantes may be saddling up soon...

Sat, 10/24/2009 - 20:27 | Link to Comment Anonymous
Sat, 10/24/2009 - 21:24 | Link to Comment Lionhead
Lionhead's picture

Not so far, although some have been less than stellar. The Treasurys' response was to get more "primary dealers" mainly large money center banks, signed up to artificially keep bid to cover ratios high, then later the FED buys back the bonds from them, aka, quantitative easing. A failed auction doesn't mean default; it shows lack of interest from buyers either by interest rates that the bidders deem too low, or lack of bidders altogether as shown by a low bid to cover ratio. The Treasury & FED are very clever in managing the auctions so far, especially after long rates began to climb last summer.

The best example of failed auctions was in the muni auction rate securities market, where the banks stepped away from the auctions in their role as primary bidders and liquidity providers which left the auction devoid of bidders for the amount of sellers who wanted to sell their securities leaving thousands of folks screwed.


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