Last Wednesday, when the Fed's reverse repo facility hit just shy of half a trillion dollars (it has since risen to a new record $547.8BN), we said that "Wall Street Scrambles To Figure Out What Comes Next" in which we showed that while some banks expect the Fed to hike its IOER and Reverse Repo rates (such as BofA, JPM and Wrightson ICAP), others see the Fed standing pat again (Jefferies, Credit Suisse and BMO), a case bolstered by the WSJ's Fed whisperer, Michael Darby, who suggested that the Fed was ok with the reverse repo being at half a trillion, and thus is unlikely to make any changes to its adminstered rates.
Alas, with the Street evenly split in two camps on the fate of the IOER/RRP rates, the confusion among traders remains, and so in attempt to explain away some of the confusion, late last week, Std Chartered's top FX and rates strategists, Steve Englander and John Davies, penned a report describing why the "Punchbowl is overflowing into money markets" and what the Fed can do in response.
Here is the one minute summary:
- The Fed may eventually feel compelled to tweak IOER and RRP but can avoid doing so at the June FOMC
- RRP usage is likely to rise further as the drawdown in the Treasury cash balance continues
- Yellen’s view that a higher rate environment would be a plus makes sense without being UST-negative
- Still, higher long-term yields could take the pressure off short-term rates
Below we present some of the key highlights from their note, in which they make the critical observation that "It is very unusual for the Treasury Secretary to talk up yields"
The surge in Reverse Repurchase Facility (RRP) usage over recent weeks has supported speculation that the Fed may tweak administered rates higher. The Fed has made it clear that any adjustments to administered rates will be treated as technical fixes, not monetary policy moves. Nevertheless, focus remains on whether the Fed deems it necessary to adjust Interest on Excess Reserves (IOER) and the RRP offering rate. Our view is as follows:
- With effective Fed Funds (EFFR) generally steady at 6bps, we expect the Fed will opt for the status quo at the 16 June FOMC meeting.
- Reverse repo operations will probably increase even further as the Treasury General Account (TGA) falls.
- We think the Fed would move IOER and RRP intra-meeting if EFFR falls to 5bps or below other than at month-end. Eventually the Fed will likely move to firm money market rates but would avoid such a move if possible.
- Treasury Secretary Yellen’s openness to higher yields may reflect issues that occur when Fed balance sheet expansion prevents yield spreads from widening as much as investors see as appropriate given issuance.
As we have discussed extensively in recent weeks, the decline in EFFR as largely driven by the boost to liquidity from the recent drawdown in the Treasury’s cash balance on top of ongoing quantitative easing (QE) by the Fed.
This drawdown is related to the debt-ceiling suspension that expires end-July and could have $600bn further to go. The Fed has no say in this, and adjusting the pace of QE to try to deal with the consequences would be a blunt and risky approach. Near-term, RRP usage is likely to rise further. Average demand per counterparty has reached $10-12Bn in recent days but the Fed’s counterparty limit was raised to $80Bn in March.
Yet remarkably, recent remarks from Treasury Secretary Yellen that “a slightly higher interest rate environment…would actually be a plus for society’s point of view and the Fed’s point of view” caught the market’s attention but triggered only a temporary blip higher in UST yields. She has mentioned higher yields twice in recent weeks, so it is unlikely to be an accident or misstatement"" according to the Std Chartered duo who note that "nevertheless, it is unusual for a treasury secretary to endorse higher borrowing costs."
Yellen also commented that “we’ve been fighting inflation that’s too low and interest rates that are too low now for a decade”. In our view, both her comments and the market reaction are fair. In the 1930s Jacob Viner argued for fiscal policy on the grounds that it would push up long-term interest rates and make short-term monetary policy more effective.
Yellen’s comments on inflation and (presumably) real yields can be seen in the same light. If real yields increase because of government borrowing for long-term investment, that is a plus provided that the real return on the investment exceeds borrowing costs.
Similarly, if inflation and inflation expectations move towards target rather than undershooting, any level of nominal policy rates becomes more stimulatory. Aggressive macro policy settings can push both real yields and inflation breakevens higher while improving economic outcomes. As Englander explains, "if unchanged policy rates accompany the higher market yields, then the lower real yields would mean employment and inflation targets are reached more quickly" while from the Fed’s perspective, it would suggest that its new policy framework is gaining traction and ultimately mean that it has more ammunition to support the economy if and when the next recession arrives.
From the market’s perspective, Std Chartered thinks that such an outlook is already largely priced in. Indeed, the breakeven curve implies a near-term pick-up in inflation beyond what the Fed’s transitory view assumes, but longer-term spreads look consistent with the 2% average inflation target. 5Y5Y USD OIS is currently around 2%, so below the Fed’s 2.5% median longer-run policy rate projections, but it hit 2.4% when UST yields registered their YTD highs in Q1.
On balance, Englander concludes that Yellen was likely defending the Biden administration’s fiscal plans much more than stating a view on Fed QE and policy rates. However, he also notes that "it is striking when the Treasurer of a public or private entity argues for higher borrowing costs. This unusual situation may reflect the fear that QE is not leading to more bank loans." If true, that would remove one of the major monetary policy justifications for QE.
Or, summarizing what we have always said about the catastrophic experiment that is QE, Englander notes that "the Fed would be paying for government debt with new reserves and preventing yields from going negative by paying a floor rate on excess reserves, but not generating additional lending activity. The higher yields that Yellen was welcoming may be a way of creating more attractive investment opportunities for financial institutions with excess reserves on hand. The higher yields further along the curve would make carry more attractive, encourage lending and reduce the excess liquidity at the short end."
Still, it could be argued that her comments even stack up in terms of the front-end rates conundrum facing the Fed in the near term. According to the Std Chartered strategists, “slightly higher rate environment” would certainly be a plus for money market investors. From the Fed’s perspective it would reduce the risk that EFFR sets outside the target range and the risk that QE is seen as having reached the limit of effectiveness.
Nonetheless, Englander concludes that does the Fed is unlikely to adjust IOER/RRP as soon as 16 June. However, Yellen may be also be making the case that more debt issuance and the higher yields that would accompany the debt would be positive for the economy and resolve some of the ‘plumbing’ issues at the short end of the market. Needless to say, in a world where there has never been more debt and where the jury is very much out on whether reflation (so very need to inflate away the debt) is here to stay, the likelihood that Yellen will be just as wrong about her "benign higher rates" forecast as she was with her 2017 prediction of "no financial crisis in our lifetimes" is effectively 100%.