Portfolio Manager Commentary
Overview, strategy, and outlook: As of August 31, 2014
Money market overviewIt has now been a year since we first learned of the Federal Reserve’s (Fed’s) plan to establish an overnight repurchase agreement (repo) facility that would be open to money market funds. In the minutes of the July 30–31, 2013, meeting of the Federal Open Market Committee (FOMC) released in August 2013, we learned the FOMC had been briefed “on the potential for establishing a fixed-rate, full allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates.” As we’ve written in the August 2013, September 2013, January 2014, and April 2014 commentaries, the purpose of this new overnight reverse repurchase agreement facility (ON RRP) would be to place a floor under interest rates to improve the effectiveness of the monetary policy implementation when the FOMC chooses to raise short-term rates.
Originally, the Fed believed that paying interest to banks on their excess reserves (IOER) would achieve this goal, but it failed because the reach of IOER was too limited. In the end, the federal funds markets proved to be leaky in that some of the holders of large deposits at the Fed were ineligible to collect interest on them—notably, the government-sponsored enterprises (GSEs)—so these entities continue to invest in the repo and federal funds markets. Likewise, money market funds and other large money market participants were ineligible for IOER and market rates traded consistently below IOER. What was originally envisioned as a floor under rates in practice became a ceiling.
Tests of the new ON RRP facility, which began on September 23, 2013, indicate it can be effective at providing a floor under most rates by essentially providing a liquid, risk-free alternative investment to money market investors who are ineligible for IOER. While not all GSEs participate and not all money market participants are eligible, ON RRP seems to have captured a broad enough base such that general collateral finance (GCF) and dealer repos have rarely traded below the rate set for ON RRP.
Federal reverse repo program and GCF repo rates
Sources: Bloomberg L.P. and Federal Reserve
Past performance is no guarantee of future results.
In addition to achieving its monetary policy goal of placing a floor under rates, ON RRP has also given money market funds some much needed supply, considering other sources of liquid investments, such as bank deposits and Treasury bills, continue to contract. This is especially true at month-end and quarter-end, when some banks and dealers pull back from the repo and time deposit markets in order to meet their own regulatory hurdles. One astute market commentator documented the strong correlation between the amount of bank paper money market funds hold and the amount the money market funds invest through the ON RRP facility. As a result, ON RRP has become a substantial component of many money market funds, especially those required to invest in government securities, and data show that, in aggregate, the Fed has become one of the money market funds’ largest counterparties. Some money market fund managers have hailed ON RRP as the solution to the supply woes that have plagued the money markets for the past half-decade or more, but it now appears the Fed may not be quite as enthusiastic about ON RRP as these money market funds.
From the minutes of the FOMC’s June 17–18, 2014, meeting, we learned some FOMC members expressed a number of reservations and concerns about “potential unintended consequences” of the ON RRP facility. According to the minutes, “most participants expressed concern that in times of financial stress, the facility’s counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress.” In other words, by providing an indirect alternative to bank deposits that was unlimited in size (full allotment), ON RRP could exacerbate a bank run.
Further, “… a number of participants noted a relatively large ON RRP facility had the potential to expand the Federal Reserve’s role in financial intermediation and reshape the financial industry in ways that were difficult to anticipate.” The minutes also revealed that, “…a number of participants expressed concern about conducting monetary policy operations with nontraditional counterparties.” We also learned that where many money market participants saw the rate on ON RRP being set at or near IOER, the FOMC saw a wider spread, “… perhaps near or above the current level of 20 basis points [bps; 100 bps equals 1.00%]…” would be more effective.
As market participants were digesting this rejection by their new BFF, the minutes of the July 29–30, 2014, FOMC meeting revealed an even more diminished role for ON RRP. The committee reaffirmed the role of the “… federal funds rate as the key policy rate …” and its support of “… a target range of 25 bps for this rate at the time of liftoff and for some time thereafter.” ON RRP was pushed further back in line as “participants agreed that adjustments in the IOER rate would be the primary tool used to move the federal funds rate … and influence other money market rates.” Gone was the promise of a permanent new source of unlimited supply implied by the term full allotment used in the initial discussion of ON RRP a year ago. As tests revealed that the facility has been effective in establishing a floor under rates even with a limit on the allocation to each counterparty, the FOMC was comfortable now saying, “… the ON RRP facility should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose.”
And what happened to the idea that the rates on ON RRP and IOER would be equal? Fuggedaboutit! Instead, the FOMC voiced support for linking IOER and ON RRP to the federal funds rate, with IOER set at the top of the range and ON RRP set at the bottom—currently a spread of 25 bps.
So why the seemingly quick turnaround in attitude toward RRP? We think there are several answers to that question.
For one thing, the change is probably not all that sudden and the discussion stems from an evaluation by the FOMC of the results of its now year-long test of ON RRP. It would probably be more disturbing if, after a year of tests, it made no changes to the original layout of the facility. One of the downsides to a more transparent process at the Fed is there can be a lot of cross talk. For those of us used to speaking in one corporate voice, this can sometimes be confusing.
We must also recognize this is a sea change in the mechanics of monetary policy and the Fed is a fundamentally conservative organization that may not handle radical change all that well. That the necessity of such a dramatic change stems from the explosion in its own balance sheet, of its own doing, probably doesn’t alter that basic feature of the Fed.
The reaffirmation of federal funds as the key policy rate may stem from governance issues more than anything else. While the FOMC is empowered to set targets for federal funds and the rate for ON RRP, the rate on IOER is set by the Board of Governors under Regulation D. Turning to these new rates as key indicators would mean a transfer of authority in one direction or another that is likely not palatable or possible. It may be much easier to retain federal funds targeting by the FOMC and then base IOER and ON RRP on federal funds. The Fed is also probably looking ahead to a period of normalization when there is a natural short base for reserves among banks. If and when that day ever comes, it will be important to have preserved a method of trading those reserves.
The idea of ON RRP as a potential facilitator of a bank run probably looms larger in the minds of the FOMC members than in those of money market participants. Low probability, high negative outcome events are of utmost interest to the Fed, and because unlimited size does not appear to be necessary in order to establish a floor under money market rates, there is no need to even open the possibility—better to limit the size now than to scramble to find the right formula and do so in the midst of a crisis.
The idea that the Fed is uncomfortable with taking on a role as financial intermediary should not be discounted. These are, after all, the same folks who sponsored the transparently titled “Workshop on the Risks of Wholesale Funding”1 at the New York Fed this past month, and several Fed presidents have consistently been outspoken critics of money market funds during the recent debate on regulatory change. So the idea of actually transacting with money market funds and becoming an integral part of the woefully misnamed shadow banking system is likely an anathema to some of the FOMC members.
So where does this leave us?
If the Fed is still interested in placing a reasonably firm floor under money market rates—and every indication is that it is—then we will likely see a continuation of the ON RRP facility beyond the end of the test period. Regulatory changes mandating holdings of high-quality liquid assets by banks, money market funds, derivative markets participants, and others, along with a continued strong investor preference for liquidity, point to a strong demand for overnight investments. Prior to the test of the ON RRP, we did see repo rates dip into negative territory on occasion, so it would appear that ON RRP fixes that particular problem. We may see other high-quality liquid assets, such as Treasury bills, still trade well below the federal funds range, but that does not appear to be an impediment to the implementation of monetary policy.
So, we are put on notice that the Fed is adopting ON RRP with reservations and will not keep the program in place a moment longer than is absolutely necessary. But we are not as optimistic as the Fed about its ability to shrink its balance sheet, which now stands at an astounding $4.5 trillion and consists mostly of U.S. Treasury, agency, and mortgage-backed securities acquired in the implementation of its quantitative easing programs. So we would expect, absent a better idea, ON RRP will be a feature through this entire next cycle of tightening of monetary policy and up to the next time the Fed chooses to ease—or, in money market lives, well over a thousand overnight maturity rolls.
Who knows? By the time it’s all over we may all become BFFs yet!Rates for sample investment instruments
Current month-end % (August 2014)
|Sector||1 day||1 week||1 month||2 month||3 month||6 month||12 month|
|U.S. Treasury repurchase agreements (repos)||0.05||0.05||0.08||–||0.09||–||–|
|Fed reverse repo rate||0.05||–||–||–||–||–||–|
|U.S. Treasury bills||–||–||0.01||–||0.02||0.03||0.08|
|Agency discount notes||0.03||0.02||0.04||0.05||0.05||0.07||0.16|
|Asset-backed commercial paper—First Tier||0.13||0.14||0.15||0.18||0.21||–||–|
|Dealer commercial paper—First Tier||0.12||0.15||0.15||0.16||0.18||0.27||–|
Sources: Bloomberg L.P. and Wells Capital Management
Past performance is no guarantee of future results.
1. Federal Reserve Bank of New York; Workshop on the Risks of Wholesale Funding; August 13, 2014
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