Yesterday, @eldemonio wrote, “With the Treasury issuing gobs of short-term treasuries, money markets are chasing the higher yield and pulling liquidity out of the ON RRP. With the ON RRP buffer at practically zero, further QT and the rebuilding of the Treasury General Account (TGA) will suck liquidity out of the financial markets….This move away from the Fed’s facility will force new or renewed treasuries to be absorbed by private investors….With the bazillions of dollars of treasuries that are expected to be issued to fund the TGA, the depleted ON RRP will result in the market being less capable of absorbing them without a total freak out.
Potentially, this could create a domino effect of tightening credit / short-term funding, higher yields as competition for liquidity increases, and dogs and cats living together.”
@DrBob2 wrote, “I disagree. The balance is the total of how much money the Fed is lending overnight.”
@eldemonio wrote, “Oh, that’s why you disagree. You’re mistaken.
You think the ON RRP is a facility for the Fed to lend money. It’s the opposite. The facility borrows money from banks and money market funds, giving them a short-term treasury as collateral. Why would they do that? To provide a floor for short-term rates when there’s excess liquidity in the markets.”
I decided to research this because low liquidity in the banking system can cause a financial crisis. In fact, the Federal Reserve measures Financial Stress which is a sure-fire indication of banks being unwilling to lend to each other except at high interest rates.
Notice that there is a difference between a routine recession like 2001 (when the dot-com stock bubble burst but there wasn’t a financial crisis) and the financial crisis years of 2008 and 2020.
As the unofficial weather reporter for METAR for over 15 years it’s up to me to detect an approaching financial crisis like the red spots on an Oklahoma thunderstorm radar.
The first thing we have to realize is that the subject is liquidity – cash that can pay out immediately. A bank can have plenty of assets, even excellent assets, but only cash is cash. Silicon Valley Bank collapsed even though it had plenty of long-term Treasury bonds because they didn’t have the cash to pay a run on the bank and the bonds had lost value due to the rise in interest rates.
A financial crisis is always a crisis of cash. So overnight money is key.
Since I don’t know anything about Overnight Reverse Repo (ON RR) I asked Google Gemini.
The Federal Reserve’s Overnight Reverse Repurchase Agreement Facility (ON RRP) is a key tool used by the Fed to manage monetary policy and maintain control over short-term interest rates.
@eldemonio is correct. The Fed is not lending money to the banks. The ONRR facility is a place for banks to park their excess cash overnight.
The banks will park their excess cash where they can get some interest. If all the banks have excess cash the interest for transferring the money overnight would be low or zero. After all, why would a bank pay interest to another bank if they also have excess cash?
The Fed wants to be able to control “the lower bound” of overnight rates. They offer a slightly higher interest rate to any bank that wants to park cash.
The Fed controls the commercial banking system. Until recently the banks could hold reserves in the bank (the way I like to keep some cash at home just in case). But since March 2020, the reserve requirement for all depository institutions has been set to zero. This means that all reserves held by commercial banks at the Fed are now, by definition, “excess reserves,” and the total “Reserve Balances with Federal Reserve Banks” is a direct measure of this.
The Fed keeps track of this.
Before 2008 the banks didn’t keep their excess reserves at the Fed. But after 2008 the Fed opened this facility where they paid interest to the banks to park their cash reserves at the Fed. But the banks still kept some because there was a reserve requirement. Notice how the amount at the Fed suddenly jumped in 2020 when the Fed said that the banks don’t need to keep any reserves overnight.
This chart shows the daily interest rate (or “award rate”) that the Fed offers to its counterparties in these overnight reverse repo operations. It’s an important series to watch as it, along with the Interest Rate on Reserve Balances (IORB), sets the floor for the federal funds rate and other short-term interest rates.
The federal funds rate is the interest rate at which banks lend money to each other overnight to maintain their reserve balances.
When the Fed required banks to maintain reserve balances the fed funds rate was important because a bank that ran short would borrow overnight from another bank to maintain their reserve balance. Now that they don’t have to maintain a reserve balance they still need liquidity for normal business operations so they may still need to borrow from another bank.
The Fed now controls the fed funds rate not by managing the quantity of reserves, but by setting a floor and a ceiling for it using two key administered rates:
Interest on Reserve Balances (IORB): This is the interest rate the Fed pays to commercial banks on the money they hold in their accounts at the Fed.
Overnight Reverse Repurchase Agreement (ON RRP) Facility: This facility allows a wider range of financial institutions, including money market funds and government-sponsored enterprises, to deposit excess cash with the Fed and earn a specific rate. Like the IORB, this rate acts as a supplementary floor, as these institutions won’t lend their cash out for a lower rate than what the Fed offers.
The ON RRP is more important because it is open to some very big cash handlers not just banks. Some of these are “Shadow Banking System” financial intermediaries that facilitate the creation of credit across the global financial system but are not subject to the same regulatory oversight as traditional, chartered depository institutions (commercial banks).
The Fed’s decision to include these non-bank institutions was a key lesson from the 2008 financial crisis. The crisis highlighted how the shadow banking system, particularly the repo market, could seize up and cause widespread financial instability. By providing a direct channel for these institutions to access the safety and liquidity of the central bank, the ON RRP facility helps to reduce systemic risk and improve the overall functioning of financial markets.
The Fed changed its whole philosophy from a “scarce-reserves” system to an “ample-reserves” system. It offers the entire range of major financial actors a safe minimum interest rate on their cash reserves. The Fed can keep an eye on these reserves since everyone will park overnight cash reserves with the Fed unless they can find a higher rate somewhere else.
The Covid windfall of fiscal and monetary stimulus in 2020-21 shows as a sudden cash increase which pretty quickly stabilized into a channel that has been constant since then.
Of course, this is an aggregate view of all the ON RRP participants. Individual actors could still get themselves in trouble. But the Fed’s quick action to clean up Silicon Valley Bank shows that they are alert and won’t let the situation get out of hand in terms of allowing a failure to propagate.
@eldemonio pointed to a sharp decline in Overnight Reverse Repurchase Agreements: Treasury Securities Sold by the Federal Reserve in the Temporary Open Market Operations as a possible indicator of a future problem.
The banks still have plenty of cash (which they park overnight at the Fed). This shows up in the high stable level of the bank reserves chart.
But the ON RRP includes other financial actors besides banks. Money market funds are finding better yields from Treasury bills than from the Fed. This is why the Fed hasn’t needed to do ON RRPs much lately.
The last factor that @eldemonio mentioned was the Treasury General Account (TGA).
Fluctuations in the TGA impact the financial markets directly. It would be ideal to maintain a moderate, stable TGA. But the ever-increasing government deficits will require issuance of more Treasury debt.
Since money market funds offer higher interest than bank accounts a huge amount of cash has been deposited in money market funds ($7.3 Trillion in 1Q25 and growing fast).
After the Fed began raising rates in early 2022, there was a massive shift of money from bank deposits into money market funds, with billions of dollars moving from the banking system to the MMF industry. This was especially pronounced in 2023 following a series of regional bank failures, which prompted some depositors to move their money into the perceived safety of government-backed MMFs.
Conclusion
Systemic liquidity must include all forms of immediately available cash equivalents. Google gave this answer but it’s Shabbos and way too much work for me to do today.
Key Components of Liquidity
Bank Reserves: This is a core component of liquidity in the banking system. The relevant chart is Reserve Balances with Federal Reserve Banks (WRESBAL).
M1 Money Stock: This represents the most liquid forms of money in the hands of the public, including physical currency and checking deposits. The series is M1 Money Stock (M1SL).M1 Money Stock: This represents the most liquid forms of money in the hands of the public, including physical currency and checking deposits. The series is M1 Money Stock (M1SL).
Money Market Funds: The assets held by money market funds are a significant part of the financial system’s liquidity. The relevant series is Money Market Funds; Total Financial Assets, Level (MMMFFAQ027S).
Treasury General Account (TGA): While not a source of liquidity, the TGA is a key factor that drains it. The balance in this account, Liabilities and Capital: U.S. Treasury, General Account (WTREGEN), is an important part of the liquidity equation.
How to Create a Combined Chart on FRED
You can build a custom chart on FRED by following these steps:
-
Go to the FRED website and find the WRESBAL series.
-
On the chart page, click the “Edit Graph” button.
-
Click the “Add Series” tab and search for the other series (M1SL, MMMFAQ027S, etc.).
-
Add each series to your chart. You may need to adjust the units and frequency to be consistent, for example, by converting monthly data to a weekly average.
By viewing these series together, you can get a more complete picture of the liquidity dynamics between the central bank, the commercial banking system, and the broader shadow banking system. [end quote]
Bottom line: Many thanks to @eldemonio who opened this analysis. However, in order to get a complete picture of liquidity and risk to the markets all the factors (including money markets) must be included.
Wendy
Good morning! Here’s what Brian Sozzi, our Executive Editor, is thinking about this week.
Why AI stock tremors are ripping through portfolios