The Federal Reserve is getting more involved in debt markets as it tries to compensate for the impact of its almost
$4 trillion balance sheet on short-term interest rates.
Policy
makers are testing a new tool intended to improve their control of
near-term borrowing costs. The facility would allow banks,
broker-dealers, money-market funds and some government-sponsored
enterprises to lend the Fed unlimited amounts of cash overnight at a
fixed rate in exchange for borrowing Treasuries in so-called reverse
repo transactions.
The facility is the latest innovation from a
central bank that has participated on an unprecedented scale in U.S.
debt markets since the credit crisis began in 2007. It’s designed to
help policy makers -- buying $85 billion of bonds a month -- siphon off
excess cash in the banking system when they begin to tighten policy.
Three rounds of so-called quantitative easing have enlarged the Fed’s
balance sheet to almost $3.8 trillion.
The new tool -- called
the fixed-rate, full-allotment overnight reverse repo facility -- also
is aimed at helping Fed officials address distortions in the market
caused by their securities purchases.
“It will serve to put whatever floor they want under rates,” said
Lou Crandall,
chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.
“You’re providing pretty broad-based access to Fed balances as an
investment option.”
Limited Effect
While the Fed
gained the ability in 2008 to pay interest on cash it holds in the form
of excess bank reserves, that tool has limited effect in anchoring
borrowing costs because only banks could park their funds at the central
bank, Crandall said. By now offering to pay a fixed rate to a wider
range of counterparties for their cash overnight, policy makers should
be able to improve their control of near-term rates, he said.
The
Federal Reserve Bank of New York has been testing the tool since last
month. It is the branch of the Fed that implements monetary policy, such
as by purchasing securities it holds in the so-called System Open
Market Account.
“By offering a new, essentially risk-free
investment, one would expect that anyone with access to such a facility
would generally be unwilling to lend instead to someone else” at a lower
rate, New York Fed President
William C. Dudley said in a speech in New York Sept. 23.
Securities
dealers use repos to finance holdings and increase leverage.
Money-market mutual funds, the primary cash providers in the repo
market, use the agreements as a means to earn interest on cash through
short-term, lower-risk investments.
Beneficial Source
“When
the Fed’s facility becomes fully functional, we think that is going to
become a really beneficial source of high-quality supply that
money-market funds are hopefully going to be very involved in,” said
Peter Yi,
director of short-duration fixed income at Northern Trust Corp., which
has $803 billion in assets under management. “That has been one of the
bigger game changers in terms of what can help the supply story in the
future. Since it’s a fixed-rate facility, the Fed is going to be able to
have pretty meaningful control over short-term rates and keep
volatility around them more contained.”
Rates on some Treasury
bills and in the repo market slid below zero as the Fed’s three QE
programs reduced the amount of government debt available. At the same
time, heightened regulations that require banks to boost their capital
have increased demand for so-called risk-free assets such as Treasuries.
Negative Zone
Treasury bills that mature in a month traded
close to zero
percent between the start of May and the end of September, falling into
the negative zone several times including as recently as Sept. 27.
Yields surged last week to the highest since 2008, ending at 0.2484
percent, as investors shunned securities at risk of default while
Congress struggled to reach an agreement that would lift the debt
ceiling.
Under QE, policy makers direct the markets desk at the
New York Fed to buy securities from primary dealers, or brokers who are
authorized to trade directly with the central bank. That adds funds to
the dealers’ accounts and creates reserves at their clearing banks. Fed
Chairman
Ben S. Bernanke
said Feb. 27 that the central bank may not sell the bonds on its
balance sheet as part of its eventual exit from unprecedented stimulus.
With
“the amount of bonds that have been piling up on the Fed’s System Open
Market Account” there “has been a collateral shortage,” said
Jim Bianco,
president of Bianco Research LLC in Chicago. “What worries me about the
Fed is that in reacting to the fact that their actions have created an
unintended consequence in a free market, instead of saying ‘Oh, maybe we
ought to re-think these actions,’ their answer is ‘No, we’ll go
manipulate that problem now.’ Where does this end?”
Higher Yields
The rate for borrowing and lending Treasuries for one day in the repo market averaged
0.058 percent
between June 30 and the end of September, compared with 0.29 percent at
the end of last year, according to the Deposit Trust & Clearing
Corp. General Collateral Finance Treasury Repo Index. The rate followed
Treasury bill yields higher last week on concerns that the U.S. might
not make required payments on some debt securities later this month. The
DTCC repo rate was 0.176 percent on Oct. 11.
Repo and Treasury
bill yields have fallen most of this year, even as policy makers have
kept the target for the federal funds rate locked in a range of
zero to 0.25 percent since December 2008.
The
new facility the Fed is testing is intended to “establish a floor on
money-market rates and to improve the implementation of monetary policy
even when the balance sheet is large,” Dudley said Sept. 23.
‘Risk-Free Asset’
Allowing
the Fed to lend unlimited amounts of cash under the facility “would
increase the availability of a risk-free asset, satisfying the demand
when the appetite for safe assets increases,” Dudley said. “This should
help tighten the relationship between these and other money-market
rates.”
Short-term debt markets often have shown borrowing costs
below the 0.25 percent interest banks can earn on cash they hold at the
Fed.
The federal funds effective rate -- the average daily market rate on overnight loans between banks -- was
0.09 percent
on Oct. 10 and has traded below the interest rate on reserves for four
years. That distortion is in part because Fannie Mae and Freddie Mac,
the mortgage-finance companies under government control, became
“significant sellers” of funds in the overnight market and aren’t
eligible to place cash on deposit at the Fed, according to a December
2009 research paper by the New York district bank.
Crashing Below
“The
Fed is not allowed to pay a deposit rate to non-banks, but with the
repo facility it can pay an interest rate” on their cash to prevent
borrowing costs “from crashing too low below the target,” said
Michael Cloherty,
head of U.S. interest-rate strategy in New York at Royal Bank of
Canada’s RBC Capital Markets unit, one of 21 firms that trade directly
with the Fed.
The facility is the latest step in policy makers’
preparations for eventual withdrawal of record monetary stimulus. The
Fed has been expanding its tri-party reverse repo counterparties beyond
primary dealers since 2010 to shore up its ability to drain this
liquidity. In these arrangements, a third party acts as the agent for
the transaction and holds the security as collateral. The Fed now has
139 counterparties: 94 money-market mutual funds, six
government-sponsored entities, 18 banks and its 21 primary dealers.
‘Decent’ Control
“This is just one more tool and they’ve got a number of tools now,” said
Michael Feroli,
chief U.S. economist at JPMorgan Chase & Co. in New York. “They
will have a reasonably decent amount of control when the time comes.”
Dudley
said the central bank is testing the facility to make sure there are
“no glitches” and to observe how it “impacts individual investor demand
relative to other market rates.” Dudley said Fed officials also will
“see how sensitive that demand is to changes in market conditions, such
as quarter-end, that increase the demand for safe assets.”
The
New York Fed has removed an average of $8.74 billion a day from the
banking system through 15 tests of the fixed-rate reverse-repo facility
that began Sept. 23. The maximum bid for such transactions, which may
run through Jan. 29, was raised to $1 billion on Sept. 27 from $500
million originally. Ultimately, the facility is intended to have no
limit on the amount.
The peak of reverse repos allocated and
counterparty usage in any of the daily operations so far came on Sept.
30 as banks and funds sought to park cash safely to shore up their
balance sheets at the end of the quarter. The New York Fed drained $58.2
billion from the banking system that day, with 87 out of the 139
possible counterparties using the program.
Balance-Sheet Strains
“When
you end up seeing participation of $50 billion or more, then you’re
talking about something that is actually relieving a few of the
balance-sheet strains on days when the market is particularly tight,”
Crandall said. “It’s intended to be more than just a plumbing test.”
Given
the scarcity of Treasuries in repo markets because of the Fed’s debt
purchases, the amount of securities primary dealers borrow daily from
the central bank has risen this year. When securities are hard to obtain
in the repo market, dealers can go to the New York Fed to borrow the
debt. The central bank’s lending of Treasury notes and bonds averaged
$15.1 billion a day this year, compared with an average of $10.5 billion last year, Fed data show.
The
new facility increases the Fed’s power to control short-term funding
rates and address dysfunctions caused by its bloated balance sheet,
according to
Joe Abate, a money-market strategist in New York at Barclays Plc. That will lead to an exit that is “more smooth than people expect.”
“At
the end of the day, reserves will not matter,” Abate said. “The Fed
will have basically drawn a line in the sand because the Fed will have
said it will absorb any amount at this fixed rate. That is significant.”
To contact the reporters on this story: Caroline Salas Gage in New York at
csalas1@bloomberg.net; Liz Capo McCormick in New York at
emccormick7@bloomberg.net
To contact the editors responsible for this story: Chris Wellisz at
cwellisz@bloomberg.net; Dave Liedtka at
dliedtka@bloomberg.net
http://www.bloomberg.com/news/print/2013-10-14/fed-gets-bigger-in-markets-as-qe-prompts-new-tools.html
