The Federal Reserve's overnight reverse repurchase tool balance drops to a three-year low, market concerns about the central bank maintaining high interest rates for too long

This week, a closely watched tool of the Federal Reserve - the overnight reverse repurchase agreement (RRP) tool, which measures the level of excess cash in the financial system, has dropped to its lowest level in over three years.

According to data from the New York Fed obtained by the Financial Intelligence APP, the RRP balance reached $256.33 billion on Tuesday, slightly up from $239.4 billion on Monday, but still the lowest level since May 2021. Compared to the peak of $2.6 trillion set in December 2022, this level has dropped significantly.

Since July 2023, major financial institutions have been receiving a stable overnight return of 5.3% through RRP from the Federal Reserve, providing a strong basis for investors to maintain short-term investments. For most of last year, the number of counterparties participating in this tool was around 100, but on Monday, the number dropped to 44, the lowest level since June 2021.

The decrease in RRP usage is mainly due to the more attractive rates offered by Treasury bills. The recent sharp decline is related to companies redeeming cash from money market funds to pay taxes due on September 16th.

Wall Street strategists and economists have been closely monitoring the balance level of RRP. This tool can be seen as a "safety net", and if these excess cash reserves are depleted, investors may worry that banks will need to more frequently tap into the Fed's reserves to meet liquidity demands.

This situation could put pressure on the Federal Reserve, with critics possibly accusing the Fed of cutting its balance sheet too aggressively and maintaining high rates for too long, leading to excessive outflows of funds.

When the Fed buys more assets, funds flow into the accounts of selling banks at the Fed, increasing bank reserves' liquidity. More funds entering the Fed's balance sheet typically promote economic growth and increase bank lending. Conversely, when the Fed shrinks its balance sheet, the effect is the opposite. So far, the Fed has reduced assets by about $1.9 trillion in this tightening cycle.

From October 2017 to August 2019, the Fed also shrank its balance sheet, leading to total reserves falling to multi-year lows. At that time, borrowing costs (measured by the Secured Overnight Financing Rate SOFR) reached historic highs. SOFR is a key rate in the financial system, reflecting the daily borrowing costs of financial institutions.

After the reduction in RRP funds on Monday, borrowing costs rose by 5 basis points, with Deutsche Bank considering this increase unusually large, reaching 5.38%.

Nevertheless, current bank reserves stand at $3.4 trillion, well above pre-COVID-19 levels, indicating that reserves are still ample. In addition, to prevent excessive reserve declines, the Fed has slowed the pace of balance sheet reduction since June.

Matthew Raskin, Director of US Interest Rate Research at Deutsche Bank (formerly a senior Fed official), stated that Monday's rate hike had no impact on bank reserve conditions.

All of this indicates that there is still room for further decline in RRP balances, and market participants currently have no need to panic. Alexandra Maier of Morgan Stanley wrote on Monday, "Our strategists believe that the risk of reserve shortages by the end of the year is low." Currently, the funding situation remains good, and there is no need to worry for the time being