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.”
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.
“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.
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?”
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.
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.
“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.
“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.
“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.”
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