Much has been said about the recently announced (with the release of the Fed’s July Minutes) proposal for a full-allotment overnight reverse repo facility, some of it confused, some of it desperate to read deeply into what the Fed is suggesting with this superficially tightening process, and most of it just plain wrong.
The premise is as follows: under such a facility (call it O/N RRP), a “relatively wide set of market participants” would be eligible to lend cash to the Fed on an overnight basis, with these loans collateralized by securities held in the Fed’s SOMA portfolio (currently $3.4 trillion on a par value basis). These RRPs would differ from the O/N RRPs currently offered to the Fed’s foreign official customers and the small-value term RRPs that are being conducted with a broader set of counterparties as part of the Fed’s exit planning.
What the Fed is simply trying to do with the O/N RRP, in a few words, is alleviate collateral pressures for “high-quality assets” – the same thing that the TBAC has been whining about for the past 2 quarters – by making available an elastic supply of risk-free assets to a fairly broad set of investors. As BofA adds, “The full-allotment feature would mean that eligible investors could effectively place as much cash as they wished at a fixed rate, which would be determined in advance by the Fed.” In brief, a Fed O/N RRP facility would substantially reduce or even eliminate concerns about the lack of high quality liquid assets.
As a result of the O/N RRP, the missing link between non-banks willing to earn interest on Fed deposits at the IOER, and the prevailing rate on money markets, which is virtually at zero due to the previously described collateral shortage (most recently in the TBAC’s own words) as all non-bank institutions scramble for non-Fed umbrella collateral, would appear and the Fed would finally be able to regain control of the short-term rate market.
And yes, it does mean that absent the RRP facility, the QE unwind would have been far more problematic due to the bifurcated ST-rate market where one set of market participants have access to all the “safe” collateral in the world, while everyone else is left scrambling for leftovers.
The problem in a nutshell:
Currently, depository institutions can earn 25bp on whatever quantity of overnight deposits they choose to hold at the Fed (making it essentially a fixed-rate, full allotment facility). The original intent of the IOER tool, which was introduced in October 2008, was to establish a floor for rates even when the Fed is expanding its balance sheet and increasing excess reserves. In theory, banks should be unwilling to lend their reserves (currently $2.2tn) at rates below IOER because they would instead prefer to earn a risk-free rate of 25bp on O/N Fed deposits
However, because non-depositories are ineligible to earn interest on Fed deposits, they are willing to invest cash at rates well below IOER. As a result, key money market rates have traded closer to zero than 25bp recently (Chart 5). So why not eliminate this problem by allowing non-banks to earn interest on Fed deposits? In short, the Federal Reserve Board lacks the statutory authority to do so. However, an O/N RRP facility would fall under the purview of the FOMC, which could introduce it under its authority to direct open market operations.
RRPs would ease the shortage of high quality liquid assets
A Fed O/N RRP facility would substantially reduce or even eliminate concerns about the lack of high quality liquid assets, in our view. In recent quarters markets have grappled with a decline in the stock of short-term risk free assets even as demand is set to increase, leading to growing concerns about the potential for negative rate trading in repo and bills.
- Supply: the FDIC’s unlimited coverage on noninterest-bearing transaction deposits expired at the end of 2012. Meanwhile, the shrinking federal deficit has led to a reduction in Treasury bill supply even as the Fed’s QE program has reduced the amount of Treasury and agency MBS collateral in the repo market, which has been exacerbated by regulatory pressure on dealers to deleverage. Looking ahead, leverage ratio proposals recently issued by both the Basel Committee and US regulators could, once implemented, lead to a further substantial reduction in dealer repo balances as early as next year.
- Demand: mandatory central clearing of swaps will increase the demand for Treasury securities to satisfy initial margin requirements over time. Additionally, the SEC’s proposed money market fund reforms would likely induce investors to move cash out of variable NAV institutional prime funds and into fixed NAV government funds, which would be required to invest at least 80% of their assets in short-dated Treasury or agency securities/repos.
RRPs would disintermediate banks and dealers
A Fed RRP facility could impact the balance sheets of banks and broker dealers in a meaningful way, depending on what terms the Fed were to announce. Money market funds, securities lenders and other large cash providers would presumably be able to lend cash at the Fed at much higher rates than are currently available on Treasury and agency repos with dealers, for example. Dealers would thus be forced to compete against the Fed to attract liquidity, resulting in higher financing costs. Depending on the rate and breadth of eligible counterparties, the Fed could become by far the biggest (and most creditworthy) borrower in the repo market, with power to set a floor on repo rates.
Usage of the facility would result in a decline in reserve balances held by banks, which would also be in a position of competing with the Fed for liquidity. This would likely come as a relief to banks, however, since the banking system has been forced to accommodate an ever expanding supply of reserve balances ($2.2tn and growing) as QE has proceeded. Given that the proposed bank leverage ratio requirements mentioned above would require banks to hold capital against these reserve balances (6% for large US banks), a reduction in reserves would actually free up bank capital to support more productive lending opportunities.
That said, with the latest H.8 showing yet another decline in total bank loans and leases to below $7.3 trillion or even further into pre-Lehman territory, we doubt any bank would scramble to lend at a time when the Fed’s infinite liquidity backstop facilities are implicitly being taken away. If anything, banks will simply hoard cash ahead of the great unknown.
Some more thoughts from Bank of America on the RRP:
Timing and offered rate will be key considerations
The market impact of such a facility could be considerable, but will depend on when it is introduced and what rate the Fed decides to offer. The minutes did not offer any clues in either respect, but in our view the rate would most likely be the same as IOER or quite close to it. Of course the Fed could always vary the RRP facility rate in relation to IOER, depending on how it wants to steer market rates. While there is still considerable uncertainty about whether the Fed will actually introduce such a facility, when it would do so and what rate it would offer, short term markets (e.g. OIS and fed funds futures, short swaps and Eurodollar futures, short-dated Treasuries and term repos, etc) could at some point re-price to higher rates as details of the Fed’s plans for this facility come to light.
The timing of a potential introduction of a RRP facility will depend on the Fed’s motives. If the goal is to increase the supply of risk-free assets in order to avoid a looming collateral squeeze and attendant dislocations in short term markets, we would expect the facility to be introduced in the coming year, well before the Fed begins its exit strategy. [Note that if the Fed wanted to introduce this facility soon but did not want short-term rates to move too much higher, it could lower IOER to avoid an excessive tightening of financial conditions.] If the goal is simply to bring the fed effective closer into alignment with IOER once the exit process begins, the Fed may wait until closer to the first hike (mid-2015 in our base case). In our view, given that O/N Treasury repo rates and short-term bill yields are currently close to zero and likely headed lower from here, the Fed may choose to introduce the facility sooner rather than later.
Not evidence of a hawkish shift
Regardless of the future of this potential new facility, market participants should not interpret today’s news as an indication that the FOMC is moving closer to the beginning of rate hikes. The December 2015 Eurodollar contract yield increased by 10bp in the 2 hours after the minutes, though it is unclear whether this was motivated by news of this facility or other information revealed in the minutes. But given that mid-2014 fed funds futures contracts only sold off by 2bp, it appears that the selloff further out the curve also reflected news that the tapering timeline remains broadly on track and that there does not appear to be broad support on the FOMC for strengthening forward guidance.
In conclusion, all of the above is largely moot. If the Fed thinks it will have enough control over the exit process to be able to institute the RRP in a calm, cool and collected fashion when the “time comes” (a necessary and sufficient condition), we have a repoed bridge to sell to whomever will be chairman at that point. In the meantime, it is merely a distraction from the real story: the Fed owns 31.6% of all Treasurys and its holdings are rising at anywhere between 0.2% and 0.3% (and as much as 0.5% in case there is no taper) per week. That’s all that matters.