Fed’s Reverse Repo Shrinks Significantly: Is Market Liquidity at Risk?

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The Fed Continues to Reduce its Balance Sheet

Since June 2022, the Fed has been reducing its balance sheet to limit liquidity in financial markets in response to elevated inflation.

Initially, the Fed reduced its monthly reinvestments by $60 billion in U.S. Treasuries and $35 billion in mortgage-backed securities (MBS), totaling a reduction of $95 billion per month.

By June 2024, the Fed announced a slowdown in the pace of balance sheet reduction, lowering the amount of U.S. Treasuries not reinvested to $25 billion per month, bringing the overall reduction amount down to $60 billion.

The Federal Reserve’s balance sheet has gradually decreased from its peak of approximately $9 trillion in May 2022 to around $7 trillion currently.

Following the Fed’s official announcement of a 50-basis-point rate cut in September 2024, market discussions have emerged around potentially halting balance sheet reductions. One key factor driving these conversations is the Fed’s overnight reverse repo operations, which have been hitting new lows.

The Federal Reserve’s Overnight Reverse Repurchase Agreement (ON RRP) Program

The Federal Reserve’s overnight reverse repurchase (repo) program serves as a key tool for absorbing excess liquidity from the market. It operates by selling securities to counterparties and repurchasing them the following day.

The transaction volume peaked at $2 trillion during 2022 to 2023 but has now declined to below $200 billion. This decline indicates that excess liquidity is steadily exiting the financial system, sparking concerns that further reductions in transaction volume could lead to tighter market liquidity conditions.

However, the Federal Reserve’s balance sheet structure reveals that although the overnight reverse repo volume has fallen to $159 billion, bank reserves held at the Fed remain at a historically high level of approximately $3.2 trillion. As such, with expectations of continued rate cuts by the Fed in the future, overall market liquidity is still deemed sufficient.

The Federal Reserve Introduces Reserve Demand Elasticity (RDE)

In October 2024, the Fed introduced a new liquidity monitoring tool — Reserve Demand Elasticity (RDE). A lower RDE value implies that changes in reserve demand have a more significant impact on interest rates, signaling tighter reserves. Current data shows that the RDE remains near zero, indicating stable liquidity conditions.

Moving forward, attention will be focused on whether the Fed adjusts or halts balance sheet reductions before the depletion of RRP operations.

(Source: Federal Reserve Bank of New York)