According to the New York Fed data on Monday, August 5th, a total of 63 counterparties (money market funds and other qualifying companies) put $316.246 billion in funds into the Fed's overnight reverse repurchase (RRP) tool, the lowest level since May 2021 and three years. The tool pays an overnight interest rate of 5.30%, which also sets the lower limit for short-term interest rates.

Historical data shows that since June 28, the amount of overnight reverse repurchase instruments at the end of the second quarter has risen to $664.6 billion, the highest level this year since January 10 when it reached $680 billion, and the amount of funds held by money market funds and other counterparties in the Fed RRP has been gradually decreasing. When the financial market surged last Wednesday, it briefly rose above $410 billion, before falling to less than $350 billion.

According to some analysts, over the past three trading days, as the repo market returned to normal after the end-of-July balance sheet pressure and Treasury settlement, demand for the Fed's overnight reverse repurchase agreement has decreased by about $97 billion.

Wall Street Daily has also mentioned that the sharp drop in the scale of the Fed's overnight reverse repurchase agreement (RRP) use indicates that the market's liquidity is lighting up red lights again, and the risk of a liquidity crisis breaking out is increasing.

Sure enough, the US stock market opened sharply lower on Monday. The S&P 500 Index plummeted across all 11 sectors, with the larger cap falling by 227 points or 4.3%, ultimately falling by 3%, and Apple, which fell by more than 4.8%, both registered the largest daily decline in nearly two years since September 2022. The Dow Jones Industrial Average fell as much as 1,238 points or 3.1%, and the Nasdaq fell as much as 6.4% by more than 1,000 points. The S&P and Nasdaq both hit new three-month lows for three consecutive days.

Nearly four months ago, on April 16, the market's liquidity lit up red lights as it did today, when the scale of the Fed's overnight reverse repurchase agreement fell sharply to less than $400 billion, marking the first time RRP has fallen below the $400 billion mark since at least May 2021, in sharp contrast to the historic peak of RRP usage, which had exceeded $2.5 trillion by the end of 2022.

Some analysts pointed out that in early November last year, as the US government aggressively issued debt, money market funds gradually invested excess funds in US government bonds, causing the use of the Fed's RRP to fall below the $1 trillion mark for the first time since August 2021. Many market participants and central bankers had previously seen the popularity of the reverse repurchase instrument as a sign of excess liquidity in the financial system, and vice versa.

In terms of its operational mechanism, the Fed's overnight reverse repurchase agreement aims to attract money market funds and other counterparties to deposit funds in the Fed, and an increase in the usage of this tool represents a reduction of excess liquidity in the recovery market, while a decrease in usage represents a release of liquidity to ease market liquidity shortages.

In a reverse repurchase agreement, the Fed sells securities it holds to trading counterparties such as banks and agrees to repurchase them at a specific date in the future. Therefore, a reverse repurchase agreement can essentially be seen as a collateralized borrowing and lending activity, and it can be simply understood as a means by which the Fed reclaims excess short-term funds from the market.

Previously, some Wall Street strategists suggested that the Fed should completely stop shrinking its balance sheet under the QT before the usage of overnight reverse repurchase approaches zero. Some analysts believed that stopping quantitative tightening (QT) at that time would be too late for the Fed to avoid drastic fluctuations in the US Treasury market, and hedge funds would become the "crash fuse" for quickly reducing market liquidity.

Editor/ping