Federal Reserve's RRP Balance Drops 86% in Four Years, Liquidity Concerns Rise

The Federal Reserve's overnight reverse repurchase agreement (RRP) balance has sharply declined to its lowest level in over four years, raising concerns about the depletion of critical liquidity buffers in the financial system. On Thursday, 14 institutions collectively deposited 288 billion dollars through the RRP tool, which is used by banks, government-sponsored enterprises, and money market funds to lend to the central bank and earn interest. According to data from the New York Fed, this balance is the lowest since April 2021, with the number of participating bidders also at its lowest since that period.

Historically, the usage rate of the RRP tool has been seen as an indicator of excess liquidity in the financing market. The recent decline in its usage is due to the U.S. Treasury issuing more short-term debt to cover widening budget deficits, which attracts funds away from this key liquidity buffer. As the Treasury continues to issue short-term debt, the RRP balance has decreased from 2.14 trillion dollars at the end of July to its current level. Strategists predict that the usage rate could approach zero by the end of August, defining "exhaustion" as a range of 0 to 200 billion dollars.

Once the RRP tool nears exhaustion, cash will begin to drain from bank reserve balances. These reserves are crucial for providing a buffer to the market and ensuring smooth operations. They also determine the extent to which the Federal Reserve can proceed with its balance sheet reduction. Despite the shrinking RRP balance, money market funds, the largest users of the RRP tool, may retain some cash with the central bank to meet liquidity needs, but banks are nearly out of buffer space.

“Once the RRP balance approaches zero, there will be no additional buffer to observe, so reserves will become the focus,” said the head of U.S. rates strategy. “The key question is how low reserves can go before the Federal Reserve completely stops shrinking its balance sheet.” The Federal Reserve began reducing its bond holdings in June 2022. In April of this year, policymakers slowed the pace of quantitative tightening, reducing the monthly cap on maturing Treasury securities from 250 billion dollars to 50 billion dollars, while keeping the cap on mortgage-backed securities at 350 billion dollars.

Recent data from the Federal Reserve shows that bank reserve balances have remained relatively stable at around 3.3 trillion dollars, indicating that reserves are still ample. However, strategists predict that, excluding changes in the RRP tool, total reserve balances could fall below 3 trillion dollars by mid-September and below 2.9 trillion dollars by the end of September. A Federal Reserve governor noted that the central bank could reduce bank reserve levels to around 2.7 trillion dollars without putting pressure on reserves.