Reverse Repos Mitigate Fed’s QT

The Federal Reserve has continued to unwind the buildup in its balance sheet.  It accumulated a lot of Treasury debt and mortgage backed securities (MBS) during 4 separate rounds of quantitative easing (QE), and since early 2022 it has been letting those mature and roll off.  That action is referred to as “quantitative tightening”, or QT.

QT is a bearish force on the stock market, because it takes liquidity out of the banking system.  But QT has been getting mitigated by something else the Fed is doing.  Starting in 2021, the Fed began accepting a whole lot of “reverse repurchase agreements” or RRPs.  An RRP involves a bank borrowing Treasuries from the Fed, to make its balance sheet look better.  That bank pledges some of its loan book as collateral for the borrowed Treasuries.  The effect of this on the stock market is that RRPs lock up money in the banking system so that this money is not available to do things like help lift stock prices.  You can read the NY Fed's description of the process at https://www.newyorkfed.org/markets/rrp_faq.

When the Fed started accepting these RRPs in 2021, the Fed was still doing QE4 at a rate of about $20 billion per month, and so the liquidity-reducing effects of conducting those RRPs did not matter very much to the stock market because QE4 was still pumping up the stock market. 

In 2022, the Fed flipped to doing QT, while RRPs continued to rise, which was two bearish factors teaming up.  So the stock market understandably struggled during 2022.  While QT has continued, RRPs have been getting unwound since their peak in October 2022, and especially since mid-2023.  That drop in RRPs has helped to boost stock prices, as that locked up money goes back into the hands of banks so that it is available to help lift stock prices.

Some analysts have theorized that this bullish force will end when RRPs get to zero.  The latest data show that the NY Fed is holding just $202.8 billion of them, down from a high of $2.4 trillion in 2022.  But the Fed can always go back to doing regular repurchase agreements (not reverse ones) if the Fed wants to keep pushing money into the system.  Rising RRPs are bearish, but rising repo agreements are bullish.  The Fed did a lot of regular repos during the 2000s, and especially during 2008, before yanking the chair away just before the 2008 elections. Hmmm.

The St. Louis Federal Reserve makes daily data available at their FRED web site for RRPs held by the NY Fed.  https://fred.stlouisfed.org/data/RRPONTSYD  There are additional RRPs done separately by other regional Federal Reserve Banks (FRBs), but the NY Fed is the main avenue for the big banks to engage in these arrangements. 

In our McClellan Market Report and our Daily Edition, we have taken to tracking the daily changes in RRPs quite frequently lately, because of their strong correlation to stock prices.  But working with these data requires the analyst to make a couple of adjustments.

The first is to invert the data plot, to better show the correlation to stock prices.  The second adjustment is to shift forward the RRP data plot by 5 trading days to reveal how there is a bit of a lag in how that liquidity effect impacts stock prices.  That's right, the RRPs data give us a week-ahead road map for the stock market. 

One must also take into account the large end of quarter effect in these RRP data.  Banks tend to make big spikes in their RRP holdings at the end of each calendar quarter, for the purposes of window dressing.  These spikes get unwound right away once the new quarter begins, and these events do not seem to flow through into stock price movements.  So when looking at these data at the end of a quarter, you have to just put a thumb over those spikes on the chart and ignore them for a few days. 

At the end of September 2024, RRPs at the NY Fed spiked up to $465.6 billion, but have now dropped to just $202.8 billion.  That represents a whole lot of additional liquidity being made available to the financial markets, and it has not yet all had the chance to flow through into the stock market.