Fed reverse repo hits $2.3T, but what does it mean for crypto investors?

The US Federal Reserve (FED) recently began an effort to reduce its $8.9 trillion balance sheet by halting billions of dollars worth of government bonds and bond purchases. The measures were implemented in June 2022 and coincided with the total crypto market capitalization falling below $1.2 trillion, the lowest level since January 2021.

A similar movement occurred with the Russell 2000, which reached 1,650 points on June 16, levels not seen since November 2020. Since this fall, the index has risen 16.5%, while the overall crypto market value has not been able to recover the level of 1.2 trillion dollars. .

This apparent disconnect between the crypto and stock markets has investors questioning whether the Federal Reserve’s growing balance sheet could lead to a longer-than-expected crypto winter.

The FED will do whatever it takes to fight inflation

To cushion the economic downturn caused by restrictive government-imposed measures during the Covid-19 pandemic, the Federal Reserve added $4.7 trillion to bonds and mortgage-backed securities from January 2020 to February 2022.

The unexpected result of these efforts was 40-year high inflation, and in June US consumer prices jumped 9.1% compared to 2021. On July 13, President Joe Biden said June inflation data was “unacceptably high”. Furthermore, Federal Reserve Chairman Jerome Powell stated on July 27:

“It is important that we get inflation down to our 2 per cent target if we are to have a sustained period of strong labor market conditions that benefit everyone.”

It is the core reason why the central bank is withdrawing its stimulus activities at an unprecedented speed.

Financial institutions have a cash glut problem

A “repurchase agreement”, or repo, is a short-term transaction with a repurchase guarantee. Similar to a secured loan, a borrower sells securities in exchange for an overnight interest under this contractual arrangement.

In a “reverse repo”, market participants lend cash to the US Federal Reserve in exchange for US Treasuries and agency-backed securities. The lending side includes hedge funds, financial institutions and pension funds.

If these money managers are not willing to allocate capital to lending products or even offer credit to their counterparties, then having so much cash on hand is not in itself positive because they have to provide returns to depositors.

On July 29, the Federal Reserve’s Overnight Reverse Repo Facility reached $2.3 trillion, approaching a record high. But keeping so much money in short-term interest-bearing funds will cause investors to bleed long-term given today’s high inflation. One thing that is possible is that this excessive liquidity will eventually move into risk markets and assets.

While the record high demand for parking cash may signal a lack of confidence in counterparty credit or even a weak economy, for risky assets, there is an opportunity for increased supply.

Sure, if one believes that the economy will recover, cryptocurrencies and volatile assets are the last places on earth to seek refuge. But at some point, these investors will not take further losses by relying on short-term debt instruments that do not cover inflation.

Think of the reverse repo as a “security tax”, a loss someone is willing to incur for the lowest possible risk – the Federal Reserve. At some point, investors will either regain confidence in the economy, which positively affects risky assets, or they will no longer accept returns below the level of inflation.

In short, all that cash is waiting on the sidelines for an entry point, whether it’s real estate, bonds, stocks, currencies, commodities, or crypto. Unless runaway inflation magically disappears, some of that $2.3 trillion will eventually flow into other assets.

The views and opinions expressed herein are solely those of author and do not necessarily reflect the views of Cointelegraph. Every investment and trade involves risk. You should do your own research when making a decision.