Thread by @dampedspring

Why do repo rates change and what do they have to do with reserves. This is a super technical issue and there are better folks to follow on this topic than me but I'll give it a go.

Firstly what are the two sides of a repo transaction and why do they want to interact.

One side is a guy with a bank deposit he wants to earn interest on. The other is a guy who wants to borrow money overnight and has assets he owns that he is willing to provide as collateral to the loan. We can go down a level on each side but for now let's keep it simple.

Most repo transactions are done with UST as the collateral and most UST collatarel used is TBills but. UST's are also highly common collateral but do to the marked to market risk they offer less borrowing capacity per unit of notional (higher haircut)

Anyway the repo occurs when a lender/saver lends cash to a borrower and the borrower pledges collateral. An interest rate is negotiated between the parties.

There are NO bank reserves involved in the transaction as the lender had a bank deposit which he hands to the borrower

While I just said no bank reserves are involved in the transaction I was talking about bank reserves in aggregate. Both sides of the transaction DO impact the bank reserves of their particular bank.

If JPM is the lender's bank and C is the borrowers' bank. JPM reduces reserves and C increase reserves to settle the deposit shift.

Because that could stress an individual bank whose depositors decide to enter repo transactions with borrowers at other banks reserve stress can occur. If there are abundant system wide reserves it's also pretty likely that individual banks have abundant reserves so reserves

matter for that reason. Less reserves with lots of Repo volume could mean some stress in individual banks

But before we deal with banks both from a greasing the skids standpoint and a party to a repo transaction let's step back to the simple example

A saver is constantly looking for the highest return on cash at all times. Most of these large savings involved in repo are large institutions which corporations and individuals provide their bank deposit to help them get interest. Perhaps the biggest most relevant institution

Is the MMF manager. They have four primary places to lend cash

Bills
RRP
Wholesale bank deposits
Repo market lending

Wholesale bank deposits are structurally low interest rate payers so those aren't used much

Bills are not overnight and so require MMF mangers to lock in rates for days weeks and months. RRP offers a low interest rate near or at the low end of the fed funds rate. Repo rates are the ones that fluctuate with supply and demand overnight. Bills fluctuate as well.

The MMF is constantly comparing those alternatives and directing money to the most attractive place.

During QT when the fed is getting paid back on maturing net debt the private sector is paying the fed back. The way they do that is with bank deposits if they are non banks

Though the mechanics is the deposit is spent and reserves move from the depositors bank to the Fed

MMF's pay the Fed back by reducing their RRP investment (thought they could also sell and asset to a bank or a non bank deposit holder or reduce repo lending

And banks of course pay the Fed back by sending a reserve.

But what happens in QT is lendable cash declines. Which reduces supply of cash to all who want to borrow it. But again it's not the reserve decrease its the investor who has cash and wants to lend that loses resources

That less lendable cash tends to raise repo rates AND Bills rates

The borrower also experiences changes in its desire to borrow money in the repo market. Let's talk about why the borrower is borrowing in the first place. Most repo borrowers are doing it because they want

Financial leverage to buy assets. Those assets could be anything at all. From real assets to meme stocks and crypto. It times of credit stress they also can need to borrow cash to pay other obligations that are suddenly coming due.

Any way borrowing demand fluctuates for

Many reasons.

Currently some big things have disrupted the supply and demand for Repo. Number 1 of course is the fairly sudden refilling of the TGA. That has gotten a bit high but not unusually so lately and in a mechanical way. That has consumed some supply of lending

On the demand side some credit stress seems to have occurred in BDC space which may have pushed up rates.

Of course borrowing for greed and momentum may also occurs but if I had to guess the issue is less lending supply due to residual QT and TGA build and some demand from

Debt paydown needs

Banks generally have no need to lend at crappy repo rates and have plenty of options to keep reserves at IORB but of course they can also jump in at elevated rates.

OTOH some banks may have scarce reserves particularly if they are exposed to credit risks

Or because their own clients are leaving for the repo market returns.

In that case the bank has a few options. It needs reserves cuz they're low. Reserves can be borrowed using repo or via SFR or DW. But the next step

Is when do they raise permanent reserves. That can take time. But unless the situation escalates the cost to the stress bank is very modest and can be minimized by jumping into SFR. They'll. Do that if they are struggling to rebalance their reserves

On the other hand IF and only if system wide reserves are indeed suddenly scarce more aggressive action by the Fed would be needed. What's happening is a little interbank rebalance and a little credit stress and a little system tightens for TGA. It will all work itself out fine.

If it doesn't the rates will have to stay elevated and and escalate and SRF will have to grow rapidly. Before that it's mostly worth ignoring