An excellent article in the New York Times this week detailed the mechanics of how the Fed will raise rates in this post-Quantitative Easing environment. The main point of the article was that setting Fed Funds to a new target level would not result in much change, given how little Fed Funds trading there is and how much cash is currently floating around. Rather, there are two major policy moves the Fed can make that will impact interest rates. Incidentally, these two actions have direct implications for securities finance, repo and rates businesses.
The article, “The Fed’s Policy Mechanics Retool for a Rise in Interest Rates” by Binyamin Appelbaum, detailed Interest on Excess Reserves (IOER) and the Reverse Repo Facility (RRP) as the two main tools the Fed can use to move rates. Given that the article was written for a generalist audience, it doesn’t actually mention IOER or the RRP by name. These policies are well known to finance professionals however and have substantial implications for financial market pricing.
A key issue is that the Fed can’t raise the Fed Funds rate and expect much to happen. There are two reasons for this: first, there is barely any traded volume in Fed Funds (some US$60 billion on a good day), and second, the huge amount of cash in the market. According to the Times, “In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.”
The Fed’s Federal Funds rate setting is supposed to set a benchmark, but who cares if the benchmark is hardly utilized? Any change to the Fed Funds rate will be window dressing compared to other policy actions the Fed could take. The Fed will raise the target Federal Funds rate, currently set at 0-25 bps, to something like 25-50 bps, but this is just for the optics. As noted by the Times, “The Fed does not plan to emphasize that this rate is now a stage prop or that the real work of raising rates will be done outside the limelight by its new tools.”
Th NYT details Interest on Excess Reserves (IOER) as a means of raising rates. Currently IOER is 25 bps, which is a decent return to banks with extra cash and provides a nice arbitrage for banks that can lend cash at the current Fed Funds rates of 14 bps. A move to 1% takes away even more incentive to lend (and frankly, there isn’t that much government-sponsored entity arbitrage to go around). The Times says that “because the glut of reserves is so great, the Fed could not easily raise rates by reducing the availability of money. Instead, the Fed plans to pre-empt the market, paying banks 1 percent interest on reserves in their Fed accounts, so banks have little reason to lend at lower rates.” Higher IOER means less cash collateral. Cash collateral reinvested at even 50 bps is less than half as interesting as IOER at 100 bps. More non-cash will be on the horizon if borrowers have their way. Either way, this might be the jolt that gets the financing markets looking at a broader diversity of warm securities that can trade in the 50 bps range and still return a positive fee or cash collateral reinvestment. These rates might even start to pay for the cost of capital…
The other big policy option is to raise the rate on the Reverse Repo Facility. The Times article didn’t provide specifics, but what would happen theoretically if the rate jumped from 5 bps today to 50 bps? Treasury Repo in the private market sector would also jump sharply. The latest DTCC GCF(R) Repo weighted average UST repo rates were at 19.8 bps. If the RRP were at 50 bps, could GCF(R) go to 70 bps? That would be a massive change in economics for short-term financing markets (but still a great arb for banks that borrow cash at 70 bps in the private market and get paid 100 bps by the Fed!)
Welcome to the new world of policy making, where IOER and the RRP are much, much more important than that old, outdated policy of changing the Federal Funds rate.
The New York Times article is here: http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html?_r=0