Early fall is the new early summer. Hark back to January, and most everyone pointed to June for the Federal Reserve to move to raise interest rates. June was the month when the Fed would move to lift the federal funds rates higher than where it has been for eight years: 13 basis points or so.
Everyone talks about the fed fund rate rising and everyone talks about the ramifications. But no one really knows what the ramifications are.
Will the yield curve flatten? Will it invert, thus killing the carry trade? Will the yield curve simply shift higher, thus allowing banks to finally funnel excess reserve dollars into higher yield debt? Will higher yields kill the debt-for-equity buy-back schemes that have kept EPS growth on an upward trajectory since 2009? It's anyone's guess.
It's also something of a guess on how the Fed will move to raise the fed funds rate?
In by-gone days – pre-2008 – the Fed could influence, and therefore hit, its target rate with certainty. Banks ran lean. They held practically no excess reserves at the Fed, and for good reason: reserves were sterile.They earned no return. This meant the pool of funds that could be lent in the federal funds market was infinitesimally small compared to required reserves banks held at the Fed.
The mechanics of manipulating the fed funds rate were straightforward. The New York branch of the Federal Reserve, under the purview of the Federal Open Markets Committee, would exogenously increase the supply of reserves on account, and thus lower the fed funds rates. If the Fed wanted the fed funds rates higher, it would reverse repo t-bills; that is, it would sell to the primary dealers and debit the requisite reserve account, thus draining reserves and pressuring the reserve account. The yield on the discounted securities would serve as floor for the fed funds rate.
But that was then. Banks no longer run lean. Excess reserves approach $2.6 trillion – and far exceed required reserves – due to the Feds asset purchases (quantitative easing) that ran through October 2014.
In addition, the Fed began paying interest on both required and excess reserves for the first time ever beginning October 2008. Interest on both required and excess reserves have been paid at 25 basis points annually. (Commentators mention that the Fed is “paying” banks not to lend, but this is wrong. Twenty-five basis point is insufficient to offset the interest earned on a proper portfolio of loans. Excess reserves are there because of the deleveraging that occurred post 2008 and lack of risk-adjusted lending opportunities.)
The Fed's perceived grip on the federal funds market was iron tight when reserves were lean. With excess reserves dwarfing past excess reserves, and even required reserves, this is no longer the case.
Today, the Fed's control on the fed funds rates is more akin to a rail system. One rail (the floor) is interest on excess reserves, currently paid at 25 basis points. The other rail (the ceiling) is the discount rate – the rate the Fed lends to banks in good standing. The discount rate is currently 75 basis points. Banks won't lend to each other below 25 basis point. They won't borrow from each other above 75 basis points.
But there is an escape valve in the system – government sponsored entities (GSEs). Because one government agency is prohibited to pay interest to another government agency, the Fed cannot pay interest to government agencies that hold reserves at the Fed. The opportunity costs to Fannie Mae, Ginnie Mae, Freddie Mac, and the Federal Home Loan Banks isn't 25-basis points, like with the commercial banks, it's zero. The GSEs can and do lend below the interest rate the Fed pays on excess reserves.
The GSEs supply loans, but there is scant demand for them. With excess reserves running high, most commercial banks are able to meet their reserve requirements. The weighted average of all trades in the fed funds market is always below the interest paid on excess reserves. This is why the federal funds rate is 13 basis points, not 25 basis points.
If the Fed wants to see the federal funds rate rise, it needs needs to control excess reserves.
The Fed could sell $2.6 trillion of the $4.5 billion of the U.S. Treasury and mortgage-back securities it has on account. That won't happen. The Fed would need to sell in excess of $2.6 trillion in par-value debt because of the precipitous drop in value and rise in yield that would ensue. What's more, the losses the Fed would take on these securities would likely wipe out is $58 billion capital base. A wholesale sale of securities is out of the question
One solution is to pass legislation that provides an exception for the GSEs, so the Fed could start to pay interest on their reserves. Precluding that, the Fed could allow the GSEs (as well as money market funds) to participate in the overnight reverse repo market -- something they normally can’t do. This at least prevents them from undermining the Fed's target floor.
The likely scenario is for the Fed to raise the interest rate it pays on excess reserves, pay interest to the GSEs or let the GSEs participant in the reverse repo market, and reverse repo its Treasury holdings as needed.
How this plays out is the great unknown. The Fed holds few short-term U.S. Treasury bills. These discounted instruments were the instruments of choice in repo and reverse repo operations in days gone by. Today, the Fed holds primarily longer term coupon-paying notes and bonds.I've yet to read what instruments the Fed plans to use in the reverse repo market.
Then again, it might not matter. The Fed could do nothing and simply chat its way to higher interest rates.
Amplified chatter on a possible fed funds rate increase has market participants queued up like wildebeest on the banks of a crocodile-infested river. Everyone wants to get to the other side, but no one wants to take the plunge. Here, the Fed can count on a few alpha wildebeest to get everyone to traverse the waters to higher interest rates. This isn't unreasonable. A couple months ago, Bill Gross and Jeffrey Gundlach both concurred that German bunds were a “short of a lifetime,” hence the 50-basis point spike in the yield on the 10-year German bund. The yield on the 10-year U.S. Treasury note was up 35 basis points.
Again, how it all plays out (if it plays out at all) is anyone's guess, including the Fed's. It's little wonder that the Fed has drug its feet on interest rates. There is no precedence to fall back on. The decision to move on interest rates is putatively data driven, but the data are never just right. We've been told the Fed won't move until the data are right, but that's not right either. If the Fed thinks the time is right, the data will be conjured to support any decision.
Everyone talks about the fed fund rate rising and everyone talks about the ramifications. But no one really knows what the ramifications are.
Will the yield curve flatten? Will it invert, thus killing the carry trade? Will the yield curve simply shift higher, thus allowing banks to finally funnel excess reserve dollars into higher yield debt? Will higher yields kill the debt-for-equity buy-back schemes that have kept EPS growth on an upward trajectory since 2009? It's anyone's guess.
It's also something of a guess on how the Fed will move to raise the fed funds rate?
In by-gone days – pre-2008 – the Fed could influence, and therefore hit, its target rate with certainty. Banks ran lean. They held practically no excess reserves at the Fed, and for good reason: reserves were sterile.They earned no return. This meant the pool of funds that could be lent in the federal funds market was infinitesimally small compared to required reserves banks held at the Fed.
The mechanics of manipulating the fed funds rate were straightforward. The New York branch of the Federal Reserve, under the purview of the Federal Open Markets Committee, would exogenously increase the supply of reserves on account, and thus lower the fed funds rates. If the Fed wanted the fed funds rates higher, it would reverse repo t-bills; that is, it would sell to the primary dealers and debit the requisite reserve account, thus draining reserves and pressuring the reserve account. The yield on the discounted securities would serve as floor for the fed funds rate.
But that was then. Banks no longer run lean. Excess reserves approach $2.6 trillion – and far exceed required reserves – due to the Feds asset purchases (quantitative easing) that ran through October 2014.
In addition, the Fed began paying interest on both required and excess reserves for the first time ever beginning October 2008. Interest on both required and excess reserves have been paid at 25 basis points annually. (Commentators mention that the Fed is “paying” banks not to lend, but this is wrong. Twenty-five basis point is insufficient to offset the interest earned on a proper portfolio of loans. Excess reserves are there because of the deleveraging that occurred post 2008 and lack of risk-adjusted lending opportunities.)
The Fed's perceived grip on the federal funds market was iron tight when reserves were lean. With excess reserves dwarfing past excess reserves, and even required reserves, this is no longer the case.
Today, the Fed's control on the fed funds rates is more akin to a rail system. One rail (the floor) is interest on excess reserves, currently paid at 25 basis points. The other rail (the ceiling) is the discount rate – the rate the Fed lends to banks in good standing. The discount rate is currently 75 basis points. Banks won't lend to each other below 25 basis point. They won't borrow from each other above 75 basis points.
But there is an escape valve in the system – government sponsored entities (GSEs). Because one government agency is prohibited to pay interest to another government agency, the Fed cannot pay interest to government agencies that hold reserves at the Fed. The opportunity costs to Fannie Mae, Ginnie Mae, Freddie Mac, and the Federal Home Loan Banks isn't 25-basis points, like with the commercial banks, it's zero. The GSEs can and do lend below the interest rate the Fed pays on excess reserves.
The GSEs supply loans, but there is scant demand for them. With excess reserves running high, most commercial banks are able to meet their reserve requirements. The weighted average of all trades in the fed funds market is always below the interest paid on excess reserves. This is why the federal funds rate is 13 basis points, not 25 basis points.
If the Fed wants to see the federal funds rate rise, it needs needs to control excess reserves.
The Fed could sell $2.6 trillion of the $4.5 billion of the U.S. Treasury and mortgage-back securities it has on account. That won't happen. The Fed would need to sell in excess of $2.6 trillion in par-value debt because of the precipitous drop in value and rise in yield that would ensue. What's more, the losses the Fed would take on these securities would likely wipe out is $58 billion capital base. A wholesale sale of securities is out of the question
One solution is to pass legislation that provides an exception for the GSEs, so the Fed could start to pay interest on their reserves. Precluding that, the Fed could allow the GSEs (as well as money market funds) to participate in the overnight reverse repo market -- something they normally can’t do. This at least prevents them from undermining the Fed's target floor.
The likely scenario is for the Fed to raise the interest rate it pays on excess reserves, pay interest to the GSEs or let the GSEs participant in the reverse repo market, and reverse repo its Treasury holdings as needed.
How this plays out is the great unknown. The Fed holds few short-term U.S. Treasury bills. These discounted instruments were the instruments of choice in repo and reverse repo operations in days gone by. Today, the Fed holds primarily longer term coupon-paying notes and bonds.I've yet to read what instruments the Fed plans to use in the reverse repo market.
Then again, it might not matter. The Fed could do nothing and simply chat its way to higher interest rates.
Amplified chatter on a possible fed funds rate increase has market participants queued up like wildebeest on the banks of a crocodile-infested river. Everyone wants to get to the other side, but no one wants to take the plunge. Here, the Fed can count on a few alpha wildebeest to get everyone to traverse the waters to higher interest rates. This isn't unreasonable. A couple months ago, Bill Gross and Jeffrey Gundlach both concurred that German bunds were a “short of a lifetime,” hence the 50-basis point spike in the yield on the 10-year German bund. The yield on the 10-year U.S. Treasury note was up 35 basis points.
Again, how it all plays out (if it plays out at all) is anyone's guess, including the Fed's. It's little wonder that the Fed has drug its feet on interest rates. There is no precedence to fall back on. The decision to move on interest rates is putatively data driven, but the data are never just right. We've been told the Fed won't move until the data are right, but that's not right either. If the Fed thinks the time is right, the data will be conjured to support any decision.
RSS Feed