Reverse Repo Drain Isn’t the Problem

The Treasury’s Borrowing Spree Is the Real Crisis

There’s been a ton of attention lately on reverse repos, something virtually no one knew about three years ago. Just like how the wars in Israel and the Ukraine instantly made countless people into Middle East and European policy “experts,” now there are bad takes everywhere on reverse repos. So, strap yourself in and find out why the sky’s not falling, even if reverse repos are.

First, what the heck is a reverse repo? Is that when your car gets repossessed and then you get it back? No, it’s actually a facility at the Federal Reserve and it’s shorthand for Reverse Repurchase Agreement, or RRP.

It’s the opposite of a repurchase agreement, or repo, another Fed facility where you can go for a very short-term loan, say 24 hours (although they can be longer). The Fed gives you money and you post collateral, often a US Treasury. When it’s time to repay the principal, you pay a little extra that we call interest.

Repos are a way to inject liquidity almost instantly and prevent interest rates from going too high relative to the Fed’s interest rate target, like in late 2019. The facility was trending down sharply as the Fed sold securities, but it spiked even higher in early 2020. The collapse of several banks in March of this year caused another spike.

Reverse that whole process and you have a reverse repo. You give the Fed money and the central bank posts collateral, often a US Treasury. When that short-term loan is up, you get your principal back with interest. Wait, wait, wait – why are you loaning money to the people with a money printer? Excellent question.

Just as repos inject liquidity, reverse repos soak it up. When you loan money to Fed, they don’t do anything with it – it literally just sits on a spreadsheet overnight, removed from the dollars circulating through the economy. For all intents and purposes, those dollars cease to exist – temporarily.

Remember this is just a short-term loan, an overnight “fix” until the cash and collateral return to their original owners. Both repos and reverse repos allow the Fed time to adjust the amount of money in circulation through their buying and selling of securities, or Open Market Operations (OMO).

The use of both repos and reverse repos tends to be relatively low and if usage spikes, the Fed corrects course and adjusts its OMO to increase or decrease bank reserves.

But that changed in March 2021. That’s when the Fed for the first time definitively knew they had an inflation problem. And they ignored it. On purpose.

Turn the clock back to early 2021 and the Fed was desperate to square the circle: continue creating trillions of dollars for the Treasury to spend but minimize inflation. Purposely letting the reverse repo facility go buck wild was their answer.

Here’s the quick and dirty version: the Fed purchased Treasuries, using money it created ex nihilo. 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 $1.2 trillion[1] as of Thursday? Because supply and demand are coming back into balance.

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

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 big 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—but that’s a story for a future post…

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[1] Many people only look at part of the reverse repo market, like just those which use Treasuries as collateral or just the domestic market. Since they all pay interest and all have the effect of sterilizing money, all reverse repos are included here.