Tuesday, January 3, 2023

The Fed's Reverse Repo: Scrap It!


The Fed runs an overnight deposit facility for banks and money market funds known as the O/N Reverse Repo (ONRR).  Technically it is a sale and buyback operation (repo = repurchase) of Treasury securities on the Fed's portfolio. Practically, it is a deposit backed by Treasuries. The Fed currently pays interest at a very substantial 4.30% in order to keep its monetary policy tight, ie maintain short term rates in line with its target of around 4.25-4.50%.

The amount deposited just reached yet another all time high of $2.55 trillion - yes, that trillion with a T. Window-dressing is always a factor at year end, but it is still an absolutely enormous amount of money being parked, ultimately at the expense of the American taxpayer.

Doing a quick calculation, at this level it costs the Fed $110 billion annualized in interest.  Some observations:

  • The $110 billion is, of course, new money that enters the system, ie it is a form of QE.  Since the Fed is removing approx. $95 billion/month in its QT operations, the ONRR makes QT considerably less effective on the whole (12x95-110 = $1.03 trillion vs $1.14 trillion of liquidity withdrawn).
  • The interest rate paid at 4.30% is now higher, and significantly so, than the average earned by the Fed on its Treasury portfolio.  In other words, the Fed is running the ONRR at a net loss. The chart below shows the ONRR rate (blue) and the current yield on 10-year Treasuries (red).  And keep in mind that the Fed is likely earning substantially less on its overall portfolio than the current yield of 10 year bonds.  If I had to guess, I would say the Fed has a negative carry of around 100 bp (1%) on its ONRR, or around $25.5 billion per year (again, current levels annualized).         *** Addendum: I'm being too conservative here: the likely negative carry is DOUBLE that.  I just looked at the Fed's 3Q22 income statement and I calculate a current yield on its portfolio of only approx. 2%.  This means the Fed is borrowing $2.55 trillion at 4.30% and lending it out to the Treasury/mortgage originators at 2%... do the math: 2.55x(4.30-2.00) = $58.6 billion negative carry.

Digging a little deeper into the Fed's 3Q22 financial statement we see that their Net Interest Income (NII) (interest received minus interest paid) for the first 9 months of 2022 came to $83 billion and for the 3Q alone to $13.8 billion - meaning that while the first two months were running at $34.6 billion each, the third quarter NII collapsed by -60%.  And it's - essentially - all because of the enormous drain of the ONRR.

If we annualize everything at current levels, the Fed will end up its next 12 months with a NII of around $25 billion, a very far cry from $117 billion in 2021.  Given that its expenses run at approx. $10 billion/year, the Fed will only make around $15 billion net - at best. 

Keep in mind, the Fed remitted $107 billion to the Treasury in 2021 and it looks like it won't even come close to that in 2022 and certainly not in 2023 - UNLESS:

It makes no sense to me to keep running the ONRR like this and it should be scrapped.  How should the Fed keep its monetary policy on track, instead?  Easy: expand QT and kill three birds with one stone: 
  1. Fight inflation by reducing money supply more aggressively
  2. Stop increasing money supply via paying interest on the ONRR
  3. Stop losing money on the negative carry.

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