Fed RRP Usage Dips, Liquidity Concerns Emerge

Fed RRP Usage Hits 2021 Lows

Demand for the Federal Reserve’s (Fed) overnight reverse repurchase agreement (RRP) facility has plummeted to its lowest level in over four years. This decline is attributed to end-of-month portfolio rebalancing driving investors and banks to reallocate funds, among other factors.

On Tuesday, 17 participants deposited a total of $21.07 billion into the Fed’s overnight RRP facility. This tool allows banks, government-sponsored enterprises, and money market mutual funds to lend cash to the central bank in exchange for interest.

Data from the Federal Reserve Bank of New York shows this size is the lowest since April 2021. Just last Friday (end of the month), usage of the tool increased by approximately $46 billion as dealers reduced their balance sheets.

Reasons for the RRP Decline

The overall decline in RRP usage is largely attributed to the U.S. Treasury consistently issuing billions of dollars in short-term Treasury bills to replenish cash reserves after the U.S. debt ceiling was raised in July. As a key indicator of excess liquidity in funding markets, the RRP balance has fallen from approximately $460 billion in June (mid-year) to its current level.

The decreasing RRP usage has coincided with a growth in the Treasury General Account (TGA) balance over the summer.

Liquidity Concerns on Wall Street

This shift is prompting Wall Street to heed potential signals of stress in funding markets. Once the reverse repo facility balance approaches zero, funds will begin to drain from bank reserves. Bank reserves are crucial for the market: not only are they a "cushion" determining the amount of capital needed to maintain smooth market operations, but they also affect the maximum magnitude of the Fed’s balance sheet runoff.

The Federal Reserve closely monitors RRP usage because it helps determine the size of idle funds in the market, and also helps control short-term interest rates. The balance of this tool is currently trending toward zero and could reach zero at any time.

A JPMorgan Chase team led by Teresa Ho noted in an August report that “As the Treasury General Account (TGA) balance climbs, and given that the RRP balance is near zero, bank reserves are bearing more of the liquidity drainage; if the TGA continues to replenish, it could set the stage for funding pressures.”

However, bank reserves remain at $3.2 trillion, indicating that liquidity remains in an ample range.

The Fed's Stance

Federal Reserve Governor Christopher Waller, one of the candidates being considered by Trump for the next Fed chairman, stated in July that the Fed should be able to reduce the size of bank reserves to around $2.7 trillion. Last week, Waller again called on Fed officials to lower borrowing costs at their meeting later this month.

John Velis, BNY Mellon’s Americas macro strategist, said that the Federal Reserve’s current balance sheet size is $6.6 trillion, and if liquidity becomes scarcer in the future, the Fed may soon need to end its years-long balance sheet runoff process.

Meanwhile, the market focus has been on a potential Fed rate cut in September and threats to Fed independence. But Velis believes this may be masking the core issue the Fed has refocused on this summer – the balance sheet, market liquidity, and how to reduce bank reserves to a reasonable level without overtightening.

In September, a month typically known for high volatility, upward pressure on money market interest rates may further squeeze liquidity. This could happen even though the Fed significantly slowed the pace of monthly balance sheet runoff in March.

“Nevertheless, we think the Fed will likely soon address the risk of further declines in reserves, and explore contingency plans, such as pausing QT,” Velis wrote.

On Tuesday, global government bonds and U.S. stocks experienced a sell-off, and long-term U.S. Treasury yields rose. FactSet data showed the 10-year U.S. Treasury yield rising by approximately 5 basis points to 4.28%, while the 30-year U.S. Treasury yield approached 5%.

The Future of Liquidity and Market Stability

The interplay between RRP usage, TGA balances, and bank reserves is a crucial dynamic to watch. A shrinking RRP balance can signal a tightening of liquidity conditions, potentially impacting borrowing costs and overall financial stability. Understanding these trends is essential for investors and policymakers alike. Monitoring these factors allows for better anticipation of market volatility and informs strategies for navigating the evolving economic landscape.