July 7 (Reuters) – US banks and monetary funds are likely to invest more in the Federal Reserve’s reverse repurchase agreement in the coming months, which could lead to a reduction in bank deposits and thus lending to the money market and fixed income markets causing market turmoil, according to Credit Suisse Analyst Zoltan Pozar.
Money market funds have borrowed a record amount of Treasury bonds from the Fed under a reverse repurchase arrangement since the Fed raised its lending rate from zero to 5 basis points last month.
Under the line of credit, investors provide the Fed with overnight loans secured by Treasury bonds.
Demand has also increased as the Treasury cuts promissory notes to lower cash levels before the two-year federal debt ceiling expires later this month.
As monetary funds invest more in reverse repo transactions, they can leave fewer deposits for banks, either by withdrawing their cash to invest, or by rotating Treasury bills and allowing other investors, in turn, to raise deposits to invest in the bills.
Monetary funds are more likely to reverse repo if the yield on the promissory notes falls below 5 basis points, which would make the reverse repo mechanism relatively more attractive, Pozar said in a report on Wednesday.
Meanwhile, banks are likely to invest more in reverse repos as they continue to build up reserves through the sale of Fed bonds and as the issuance of Treasury bills is reduced.
Pozar said demand for reverse repo transactions by September is likely to surpass $ 1.3 trillion, up from $ 800 billion today.
If this increase occurs and bank reserves fall to $ 3.50 trillion, this would mean that banks have fewer lending deposits in the currency swap market, as well as in long-term Treasury bonds and mortgage-backed securities.
This can lead to credit deficits in these markets, which can create market imbalances.
“We are looking at the possibility of moving from one margin lender / buyer to another – a transition that should be smooth, but perhaps not,” Pozsar said.
As of April, banks had $ 3.87 trillion in excess reserves, according to the Fed. (Reporting by Karen Brettel in New York; editing by Alden Bentley and David Gregorio)