Debt Market Monitor (August 2021)

Debt Market Monitor (August 2021) October 5, 2021

Liquidity has been described as oxygen for a financial system. Back in the fall of 2019, when the markets went a little fuddled, the Federal Reserve (The Fed) activated a Treasury and mortgage-backed securities (MBS) buying program and handed out repurchase agreements – essentially, they floated the Repurchase Agreement (or “repo”) market, providing much-needed liquidity for short-term overnight borrowing purposes. This happened again in March 2020; however, by July 2020, the last repo matured and was unwound, returning the market to approximate normalcy.  

Now, thanks to the massive liquidity that the Fed has poured into the system in response to COVID-19 via various quantitative easing (QE) programs, the banking system is very much feeling the strain of the significant amount of reserves amassed. The Fed owns more than US$7 trillion of Treasury securities and MBS. Can there be such a thing as too much liquidity? The Fed has started doing what are being called “reverse repos” which involve the Fed selling Treasury securities to counter parties and taking their cash, thereby draining liquidity from the market – the opposite of QE. In one fell swoop on May 20th, 2020, the Fed sold US$351 billion in Treasury securities through overnight reverse repos to 48 counter parties.

Reverse repos are an indicator that the banking system is struggling to deal with the liquidity that the Fed has been injecting. The result is that there is some clamouring on Wall Street for the Fed to taper its QE purchases as the banking system is now awash in liquidity held as reserves on balance sheets.  

With one hand, as part of QE, the Fed is buying US $120 billion a month in Treasury securities and MBS and with the other, it is taking back US $351 billion through reverse repos, undoing nearly three months of QE. Some analysts describe this kind of activity as extreme and believe it has the potential to create some unintended and possibly not-so-nice side effects.  

It was Paul Volcker, the retired Chair of the Fed, who once said, “when I hear complaints about less liquidity, remember there is such a thing as too much liquidity.”