Short-term interest rates have increased dramatically since the fourth quarter of 2021 amid inflationary pressures and concerns surrounding reduced global market liquidity. The 2-year Treasury yield ended February at 1.33%, up from 0.56% at the end of November 2021, and has continued to rise throughout the first few days of March. The yield on the 10-year Treasury has also ticked up in recent months, albeit at a much slower pace than that of the 2-year instrument. As a result, the spread between the 2- and 10-year Treasury yields has contracted significantly since the beginning of the year and currently sits at approximately 23 basis points, its lowest level since March 2020. Current yield curve dynamics could be exacerbated by the Federal Reserve, which, after holding short-term rates near zero for the last two years, is set to begin a hiking cycle later this month. Increases in the federal funds rate, though likely modest (25–50 basis points per increase), could number as high as seven in 2022 and result in additional yield curve flattening.

The relationships between Treasury yields of different maturities are important considerations for investors and traditionally serve as key indicators of macroeconomic trends. Typically, longer-dated debt instruments have higher yields than short-term bonds due to increased risk and liquidity premiums, resulting in relatively wide spreads and an upward-sloping term structure of interest rates, an indication of solid growth expectations and overall economic health. An inverted yield curve, marked by short-term yields that are higher than long-term yields, is commonly considered a bear signal, as it implies that the nearer term is riskier than the longer term. Each instance of a 2/10 inversion dating back to the 1990s has been followed by a recession in the United States within the next two years.

It is important to note that a narrowing 2/10 spread does not necessarily portend an economic downturn, as most economists expect positive economic growth in 2022 and beyond given solid corporate fundamentals and strong consumer balance sheets. Still, recent sell-offs in equity markets, elevated inflation, and supply shortages stemming from the conflict in Eastern Europe are causes for concern, especially when viewed in tandem with narrowing Treasury spreads. Marquette will continue to monitor the term structure of interest rates, as well as other leading macroeconomic indicators, and advise clients accordingly.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The volatile start to the new year has all eyes on the Federal Reserve and its increasing hawkishness. As the Fed prepares to raise interest rates later this year, we look at reverse repurchase agreements and what they mean for the markets.

As part of the Federal Reserve’s efforts to maintain monetary policy and manage liquidity, the New York Fed engages in temporary transactions where reserve balances of excess liquidity are added to or reduced through repurchase (repo) and reverse repurchase (reverse repo) agreements. These operations have a short-term, self-reversing effect on bank reserves. Repurchase agreements involve the Fed purchasing Treasury securities from a counterparty (typically a large institution with excess reserves), with an agreement to resell the securities back at a slightly higher price, representing a small rate of interest. The repo transaction temporarily increases the supply of reserve balances in the banking system and provides liquidity. Reverse repurchase agreements involve the opposite, where counterparties temporarily purchase Treasury securities to be sold back at a later date. Reverse repo transactions help alleviate any undue downward pressure on the effective federal funds rate and set a floor under overnight interest rates by providing a short-term alternative investment for large institutions with excess liquidity reserves.

After a period of dormancy in the beginning of 2021, the Federal Reserve’s overnight window for reverse repurchase agreements saw a rapid rise in demand when the counterparty limit for reverse repos was raised from $30B to $80B in March. This trend continued to accelerate when the limit was again raised to $160B in September, closing out the year at a record level of $1.91T in volume. Low interest rates and the Fed’s quantitative easing efforts presented large institutions with a challenge as to where to invest record levels of excess liquidity reserves. The solution has so far been to make use of the overnight window and earn minimal interest via a risk-free investment in Treasuries.

Time will tell how the Fed will execute its monetary policy changes this year and how markets will respond to that shift. Institutions currently utilizing reverse repurchase agreements may change course once they have higher yielding alternatives, with the impact to the economy and market dependent on where those reserves go. Marquette will continue to carefully follow policy decisions from the Federal Reserve and monitor other indicators, like the demand for overnight repurchase agreements, to help provide clarity during this period of heightened market volatility.

Print PDF > Any Port in a Storm

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.