The Federal Reserve's overnight reverse repurchase balance has plummeted to a four-year low, with the key liquidity buffer nearing "exhaustion."

According to the Zhitong Finance APP, the balance of a key tool of the Federal Reserve has fallen to its lowest level in over four years, making the cash reserves of the U.S. central bank (a measure of liquidity conditions) the focus of the market. On Thursday, 14 participating institutions deposited a total of $28.8 billion through the Federal Reserve's overnight reverse repurchase agreement (RRP) tool. This tool is used by banks, government-sponsored enterprises, and money market funds, allowing institutions to earn interest by lending to the central bank. Data from the New York Fed shows that this balance is the lowest since April 2021, and the number of institutions participating in the bidding has also dropped to the lowest level since that time.

For a long time, the usage rate of the Federal Reserve's overnight reverse repurchase tool has been seen as a measure of excess liquidity in the financing market. Its usage rate is now continuously declining because the U.S. Treasury is issuing more short-term bonds to fill the growing deficit, attracting funds away from this key liquidity buffer.

Once the so-called reverse repurchase tool is nearly exhausted, cash will begin to flow out of bank reserve balances. These reserves are crucial for providing the necessary funds to buffer the market and ensure smooth market operations, and they will also determine the extent of the Federal Reserve's balance sheet reduction.

As the U.S. Treasury continues to issue tens of billions of dollars in short-term Treasury bills to replenish cash balances after raising the debt ceiling last month, the balance of the reverse repurchase tool has fallen from $214 billion at the end of July to its current level. Citigroup strategists Jason Williams and Alejandra Vasquez Plata expect its usage rate to approach zero by the end of August. They define "exhaustion" as a range of about $0 to $20 billion.

Although money market funds, the largest user group of the reverse repurchase tool, may retain some cash at the central bank to meet liquidity needs, the shrinking balance has nearly eliminated the buffer space for banks.

"Once the reverse repurchase balance approaches zero, there will be no additional buffer to observe, so reserves will become the focus of close attention," said Genadiy Goldberg, head of U.S. interest rate strategy at TD Securities. "But the key question is, to what level might reserves fall before the Federal Reserve completely stops reducing its balance sheet?"

The Federal Reserve began reducing its bond holdings in June 2022. In April of this year, policymakers slowed the pace of balance sheet reduction, lowering the monthly cap on maturing Treasury securities that can be allowed to roll off from $25 billion to $5 billion, while maintaining the monthly cap on mortgage-backed securities at $35 billion.

The latest data from the Federal Reserve shows that bank reserve balances remain stable at $3.3 trillion, indicating that current reserves are still in a plentiful range. Barclays strategist Samuel Earle stated in a report to clients on Thursday that excluding the impact of changes in the reverse repurchase tool, the total reserve balance is expected to fall below $3 trillion by mid-September and below $2.9 trillion by the end of September Federal Reserve Governor Christopher Waller is reportedly one of the candidates for the next Federal Reserve Chair being considered by President Donald Trump. Last month, he stated that the Federal Reserve should be able to reduce bank reserves to about $2.7 trillion without putting pressure on bank reserves