Record-breaking pile of cash parked at Fed facility set to shrink

Growing demand for a U.S. Federal Reserve facility, where investors store cash overnight, is expected to subside in 2022 after a record run last year, as the shortage of low-risk assets generating positive returns fades.

Investors parked record sums in 2021 in the Fed’s overnight repo facility, where cash is exchanged for ultra-safe securities such as US Treasuries. Daily use of the RRP averaged $ 1.6 billion in December, reaching a record high of $ 1.9 billion on the last day of the year. Average daily usage for December 2020 was zero.

The facility, which acts as an investment of last resort, has attracted such high demand throughout the year due to a shortage of safe, short-term Treasuries that has left investors such as money market funds less safe places to deploy their cash.

But in 2022, the popularity of the RRP will begin to wane, strategists say, as the flow of money injected into financial markets to counter the damaging effects of the pandemic begins to subside. This will provide more alternatives for investors and potentially increase the fortunes of distressed money market funds that invest in short-term assets.

“We think we’re pretty close to an overnight reverse repo peak,” said Mark Cabana, head of US rate strategy at Bank of America. “What this means for money market funds is that they finally have other interesting alternatives. The only reason silver funds invest with the Fed is because it’s their least worst option. “

Reductions in treasury bill issuance in 2021 – in favor of longer-term debt – were part of what drove the use of the RRP facility so high. Additionally, the Fed’s massive bond purchase program prompted the central bank to increase the amount of liquidity flowing into the financial system.

Demand for money market funds, which are among the biggest buyers of Treasuries, was so high that it briefly pushed government debt yields into negative territory.

Stimulus money tied to the multiple aid programs passed by Congress also raised Americans’ savings rates, which in turn increased bank deposits. Banks, which reimposed stricter capital requirements in March, began advising clients to move their money from deposits to money market funds.

But after new legislation was passed to lift the U.S. government’s borrowing limit in December, the Treasury Department is now expected to replenish its cash balance and step up short-term issuance, providing much-needed relief. .

By the end of January, Cabana said he expected the treasury’s cash balance to increase by about $ 600 billion.

The Fed also announced in December that it would accelerate the reduction of its asset purchase program, helping to further alleviate the acute mismatch between the amount of money looking for housing and the number of available securities. purchase.

While the RRP figures are mind-boggling, Fed officials have indicated little concern about the facility’s record usage in 2021. Asked about the seemingly insatiable demand to park money overnight at the central bank in July, President Jay Powell said the facility was doing “what it’s supposed to do.”

The minutes of subsequent political meetings also suggest a broad consensus within the Federal Free Market Committee that the facility was functioning as intended.

To maintain its effectiveness, the Fed has repeatedly changed the terms of the facility. The central bank increased the number of eligible counterparties that can access the RRP and increased the amount of money they can invest in it each day – an adjustment it made no later than September when it increased the daily counterparty limit of $ 160 billion.

He also started paying interest on money held overnight in June in an attempt to support the smooth functioning of short-term funding markets. This move was accompanied by a decision to increase the interest it pays on excess reserves, which are deposited with the Fed by the banks.

More recently, however, a senior Fed official cited the high use of the RRP as another signal that the central bank should move away more quickly from its ultra-accommodative monetary policy that has been in place since the start of the pandemic. .

“It’s pretty clear that we can go faster on the balance sheet, because I’ve looked at the RRP facility, and there’s about $ 1.5 billion in reserves being handed to us every day by the financial industry,” he said. Christopher Waller, a governor, said in mid-December, as he advocated for the Fed to start reducing its balance sheet by the summer. “We put so much cash in the system that the market doesn’t really want it.”

The benefits of an increase in bond issuance are expected to accrue the most to the $ 4 billion money market fund industry after a grueling year. Negative market returns in 2021 wiped out earnings and forced funds to turn away new investors.

However, tensions in the money market could reappear later in the year, warn some strategists. Although the Treasury will need to auction more short-term bills, debt issuance in 2022 is expected to decline overall, as funding requirements for budget programs have declined.

“Once the supply of bills increases more significantly, it will take money out of the RRP. But the sheer size of the Fed’s balance sheet and the level of reserves, I think, will ensure that we see some pretty big numbers there every day for at least the next few quarters, ”said Ben Jeffery, rate strategist at BMO Capital Markets. capital. .