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That sloshing sound you hear is cash flowing around the U.S. financial system, trying desperately to find a home.

Most notably, it is pouring into the reverse repo program operated by the Federal Reserve Bank of New York. The program lets eligible institutions, such as banks and money market funds, park cash overnight at the Fed.

Almost unused back in April, the reverse repo program is now taking in around half a trillion dollars a day.

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The massive upswell in reverse repos can be seen as a warning sign that the Fed’s programs to pump cash into the pandemic economy have gone a step too far. If so, investors should brace themselves for the possibility that the Fed will taper its cash-stoking tactics in the second half of the year. That, in turn, could propel longer-term interest rates upward, throwing cold water on the stock market’s high spirits.

Some signs of stress are already evident. In a statement on Wednesday after a two-day meeting, Fed officials left policy unchanged, including the target for the key short-term interest rate, but signalled they expect to raise that rate by late 2023, sooner than they indicated at their last meeting in March.

At least some Fed officials appear to be worried about mounting inflation and eager to roll back policy support. For now, though, and until the economy fully heals, the Fed indicated it intends to stick to its existing regimen – including an aggressive bond-buying program.

That program has purchased at least US$120-billion a month of Treasury and mortgage bonds since June, 2020. It is intended to help hold down longer-term interest costs by bidding up the price of bonds. (Bond prices and yields move in opposite directions.) But, combined with massive cash infusions to households from Washington, it may also be flooding the economy with more ready money than it can usefully put to work right now.

Much of the surplus cash appears to be finding a temporary home in reverse repos. In a reverse repo, the Fed sells Treasury securities to a financial institution, with the promise that it will repurchase the securities the next day. This takes the cash used to purchase the securities off the financial institution’s balance sheet overnight.

In today’s low-rate environment, the transaction is a wash in profit-and-loss terms. The repurchase takes place at the same price as the original sale, meaning the payoff to the financial institution is zero.

So why do it? Because without reverse repos, short-term interest rates could sink into negative territory. “There is so much cash in the financial system that short-term rates, including the repo rates, Treasury bills and the Fed’s policy rate, are all threatening to fall below zero,” Robert Armstrong wrote in the Financial Times this week.

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If nothing else, the flood of money into the reverse repo program provides useful context to understating the confusing signals from the bond market. Despite signs that inflation is surging, the yields on benchmark 10-year U.S. Treasuries have declined in recent weeks, despite a jump after the Fed statement.

This is the opposite of what most people predicted earlier this year. Inflation is a negative for bonds, so investors were expected to seek higher bond yields to compensate them for the risk that rising prices elsewhere in the economy will erode their buying power.

Instead, bond yields have dwindled. Since May, the yield on 10-year Treasuries have slid from around 1.70 per cent to around 1.58 per cent. (The yield on 10-year Government of Canada bonds have moved in a similar pattern, slipping from 1.60 per cent in May to around 1.44 per cent.)

What caused this rather counterintuitive decline in yields? Oliver Allen, markets economist at Capital Economics, attributed it to “non-fundamental factors” in a note Wednesday.

The biggest such factor was probably portfolio adjustments by large U.S. banks, which are required to hold large amounts of high-quality liquid assets, such as U.S. Treasuries, for regulatory reasons.

“Given that the interest rates available on other ultra-liquid and safe assets – such as central bank reserves and reverse repos – are near zero, these financial institutions may be loading up on U.S. Treasuries instead,” Mr. Allen wrote.

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The downward move in yields is likely to be reversed in coming months, he warned. He expects the 10-year U.S. Treasury yield to jump to around 2.25 per cent by year-end.

“The retreat in U.S. Treasury yields over the past month or so seems at odds with the U.S. economy’s fundamentals, and we doubt it will be sustained,” he wrote. “Our forecast that the 10-year yield will end 2021 well above its current level informs our view that U.S. equities will fail to make further gains this year.”

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