Market liquidity is flashing red again! The size of the overnight reverse repurchase agreements used by the Federal Reserve has dropped to a three-year low

On Monday, August 5th, the New York Fed data showed that 63 counterparties (money market funds and other eligible companies) placed a total of $316.246 billion in funds in the Federal Reserve's overnight reverse repurchase agreement (RRP) tool, marking the lowest level in over three years since May 2021. The tool paid an overnight interest rate of 5.30%, effectively setting the lower limit for short-term interest rates.

Historical data shows that since the end of the second quarter on June 28th, the usage of the overnight reverse repurchase tool rose to $664.6 billion, reaching the highest level since January 10th when it hit $680 billion earlier this year. The amount of funds deposited in the Fed's RRP by money market funds has been gradually decreasing, with a brief spike above $410 billion last Wednesday when the financial markets surged, before falling back to less than $350 billion.

Some analysts pointed out that over the past three trading days, as the demand for the Federal Reserve's overnight reverse repurchase agreement dropped by about $97 billion, following the normalization of the balance sheet pressure and Treasury auction settlements at the end of July.

Wall Street News has also mentioned that the sharp decline in the usage of the Federal Reserve's overnight reverse repurchase agreement (RRP) indicates a warning sign for market liquidity, with the risk of a liquidity crisis looming larger.

Indeed, U.S. stocks plummeted at the opening on Monday. All 11 sectors of the S&P 500 index collapsed, with the S&P index plunging 227 points or 4.3%, ultimately falling by 3%, and Apple dropping over 4.8%, marking the largest single-day decline in nearly two years since September 2022. The Dow Jones index fell by 1238 points or 3.1%, while the Nasdaq dropped by over 1000 points or 6.4%. The S&P and Nasdaq both hit a three-month low after three consecutive days of decline.

Nearly four months ago on April 16th, market liquidity flashed a warning sign similar to today, when the usage of the Federal Reserve's overnight reverse repurchase agreement dropped to less than $400 billion, marking the first time since at least May 2021 that the RRP fell below the $400 billion mark. This was in stark contrast to the historical peak of over $25 trillion in RRP usage at the end of 2022.

Analysts pointed out that in early November last year, as the U.S. government issued a large amount of debt, money market funds gradually invested excess funds into U.S. government bonds The usage of the Federal Reserve's RRP has dropped below the $1 trillion mark for the first time since August 2021. Many market participants and central bank officials had previously viewed the popularity of reverse repurchase agreements as a sign of excess liquidity in the financial system, and vice versa.

In terms of operation, the Federal Reserve's overnight reverse repurchase agreement aims to attract money market funds and others to deposit funds with the Federal Reserve. An increase in the usage of this tool represents the withdrawal of excess liquidity from the market, while a decrease in usage represents the release of liquidity to alleviate market liquidity shortages.

In a reverse repurchase agreement, the Federal Reserve sells securities it holds to counterparties such as banks, and agrees to repurchase the securities from the counterparties on a specific future date. Therefore, reverse repurchase agreements can essentially be seen as a collateralized borrowing activity, or simply put, a means for the Federal Reserve to withdraw excess short-term funds from the market.

Some Wall Street strategists had hinted previously that the Federal Reserve should completely halt QT balance sheet reduction before the usage of overnight reverse repurchase agreements approaches zero. Some analysts also believe that stopping quantitative tightening at that point would be too late for the Federal Reserve, leading to significant volatility in the U.S. Treasury market, with hedge funds becoming the "trigger" for rapidly reducing market liquidity