We usually discuss how to find and execute specific trades – using the Masters in Trading’s approach and tools. Although we’re searching for certain conditions for specific types of trades, it’s also important to always keep a broader market perspective or context in mind. What’s going on with the economy, the Federal Reserve (the Fed), news announcements, company fundamentals, etc. are important considerations before entering a trade. In this post, we’ll discuss how the Federal Reserve’s repo and reverse repo programs influence a broader context for market direction and our trades.
How Do the Federal Reserve’s Repurchase (Repo) and Reverse Repurchase (Reverse Repo) Agreements Work
Let’s say a bank just purchased some treasury securities. One common way to finance that purchase is to enter a repurchase agreement with the Fed. The repurchase agreement is really nothing more than a collateralized loan. The bank sells the securities to the Fed with an agreement to repurchase the securities at a slightly higher price within a specified time (often the next day). The difference between the sale price and the repurchase price is essentially the interest rate (repo rate) for the collateralized loan.
A reverse repo is just the opposite transaction. If a bank has excess reserves, it can make a collateralized loan to the Fed. The bank buys the securities from the Fed with an agreed upon sale price. The difference between the purchase and sale prices is the interest earned by the bank.
How has Reverse Repo Activity Been Bullish for the Equity Markets
The Fed’s Reverse Repo program has had a significant impact on the broader market context. During the Covid crisis, the Fed relaxed bank capital requirements (specifically the Supplementary Leverage Ratio – the SLR). In early 2021, the Fed re-implemented the SLR requirements resulting in increased capital requirements. Banks were once again required to hold capital against Fed reserve balances that resulted from deposits such as those from large money market funds. To increase their return on capital, banks want to move those large money market fund deposits off their balance sheets to free up capital to invest in riskier, higher returning assets (like providing risk capital to hedge funds).
At the same time, large money market funds are searching for yield. They aren’t getting much of a return, if any, from bank deposits and there has been a limited supply of short-term treasury securities to invest in.
So banks don’t want large money market fund deposits and large money market funds are looking for yield…the solution….the Fed’s Reverse Repo program! Large money market funds withdrew deposits from banks, lent that cash to the Fed through the Reverse Repo program and earned higher yields. Banks used that freed-up capital to invest in riskier assets. Everyone is happy (or at least happier)!
Finally…we get to the impact on the broader markets. Some of the banks’ riskier assets are now providing capital to hedge funds and other investment firms. This capital has been invested in risk-on assets essentially providing a bid or bullish force for the equity markets.
Look at how reverse repos have increased over the last year… and the continued bullish move in S & P futures:
How to Trade Equities within the Context of the Reverse Repo Program
As we review the reverse repo program for context, how can we develop an actionable trade idea? Let’s look at Masters in Trading’s new EDGE Charting Platform and how the Nasdaq futures have significantly outperformed the S & P futures over the last 6 months as the reverse repo program took off:
As we monitor reverse repo activity and see a decrease, we would expect the Nasdaq to start to underperform the S &P. That may be time to consider bearish Nasdaq position or a relative value trade – short the Nasdaq and long the S & P.
How to Trade Bonds within the Context of the Reverse Repo Program
Let’s look at the EDGE Charting Platform and see how the yield curve has moved over the last 6 months:
This is a plot of the 2-year treasury note (the /ZN futures contract) vs. the 30-year treasury note (the /ZB futures contract). Notice the downward slope during the rapid rise in reverse repos. This means the curve is flattening: 2-year rates are increasing relative to 30-year rates. Again, as we monitor reverse repo activity and see a decrease, it may be time to consider a yield curve steepening trade such as buy the NOB (Notes Over Bonds): buy the /ZN – the 10-year futures contract – and sell the /ZB – the 30 year futures contract.
The Creative Trader Wins
Successful traders do not follow the crowd… they chart their own course by digging deeper into economic, fundamental, Federal Reserve, etc. data to find relationships that others may miss. Researching and monitoring these relationships can turn into very profitable trades!
Please make sure to paper trade and thoroughly research these relationship trades before risking real money.