When the Fed unveiled its reverse repo program several years ago, it was meant to be a means for the Federal Reserve to soak up excess liquidity from domestic financial institutions when the Fed eventually proceeded to hike interest rates, as it did in mid-December. However, one look at the chart below shows something odd: while the liquidity which the domestic financial sector parked at the Fed clearly spikes at quarter and year end, this has been solely for window dressing purposes to make bank and money market balance sheets appear strong than they are for regulatory purposes, overall usage of the Fed's domestic reverse repo has actually declined since the Fed's rate hike.
There has been much confusion why this is, with experts such as Wedbush's Scott Skyrm scratching their heads and deciding that there continues to be a substantial mismatch between what the prevailing liquidity level should be at a Fed Funds rate of 25 - 50 bps, and what is actually taking place in the open market if such a thing even exists. The implication is that banks continue to find better uses for their cash than giving it to the Fed to receive the guaranteed rate which on the domestic facility is about 0.25%.
However, while use of the Fed's domestic reverse repo program has declined in recent weeks, an unexpected market participant has taken the place of domestic financial entities: foreign central banks.
As the chart below shows, the Fed's offshore peers have been aggressively parking their overnight deposits at the Fed's reverse repo facility designed for "foreign official and international accounts", one which was has been around in some iteration ever since the 1970s, and whose usage has soared by $50 billion since the Fed's rate hike and by a whopping $150 billion since the beginning of 2015.
Why the dramatic surge?
The answer is not exactly clear, but has to do with the interest that the Fed is paying on the foreign reverse repo. While the Fed for unknown reasons does not disclose what rate it pays its foreign central bank peers, according to the WSJ, analysts estimate it to be between 0.33% to 0.35%. By comparison the domestic facility is about 10 basis points lower.
As the WSJ writes, questions related to this murky facility abound: “we would like to know how the rate is determined because we want to have a clearer understanding of how the program is interrelated with the demand for bills,” said Joseph Abate, money markets analyst at Barclays PLC.
Zoltan Pozsar, a researcher at Credit Suisse Group AG , wrote in a client note this month that the rate on the foreign repo pool has been rising, giving incentive to foreign account holders to put their money there, and it would be useful if the Fed provided more information. The Fed “has some explaining to do,” he wrote.
The Fed itself keeps disclosure on the facility to a minimum. This is what the NY Fed says on its website:
The New York Fed provides limited investment services to its foreign official and international account holders. Principal among these is the foreign repurchase agreement pool (foreign repo pool). This investment service operates as follows: at the end of each business day, cash balances across these accounts are swept and invested in an overnight repurchase agreement using securities held in the System Open Market Account (SOMA). At maturity, on the following business day, the securities are repurchased at a repurchase price reflecting a rate of return tied to comparable market-based Treasury repo rates.
The foreign repo pool is a short-term liquid, U.S. dollar investment option for account holders and supports daily cash management needs to clear and settle securities. This investment service has been a standard provision of the New York Fed to foreign public sector account holders for many years and is separate from monetary policy operations, including the overnight and term reverse repo operations.
That's about all that is known about the program: the Fed keeps most details of the foreign repo program confidential, including users’ identities, the daily market-based rate, and how that rate is derived, in part to protect activity by foreign official institutions. Unlike some fixed rates, foreign reverse repo rates aren’t published daily. When asked by the WSJ, the Fed declined to comment on them.
As the WSJ's Katy Burne writes, "the program now seems to be at the center of how they are building a liquidity cushion at a time of heightened market uncertainty and relatively unattractive rates on bank customer deposits."
To be sure, the global dollar shortage first profiled here nearly a year ago is a factor:
Lately, market conditions have put a premium on the availability of U.S. dollars and lent new importance to the facility, as investor anticipation of additional Fed rate increases has squeezed emerging-market economies with weakening currencies. Because institutions have flocked to dollar assets, borrowers overseas may now struggle to raise enough cash to pay down debts.
Already, central banks in emerging markets have run down their foreign-currency reserves at the fastest pace since the financial crisis.
And yet here they are, sweeping dollar deposits and parking them at the Fed in hopes of collecting a meager interest boost.
A key factor likely has to do with with arbing short term Treasury bills: as noted above, the rate on the facility is estimate at 0.33% to 0.35%. A such it provide an immediate arbitrage to the 0.26% rate available on one-month Treasury bills.
Ironically, while the Fed's facility provide far better liquidity options, in that the cash is only locked up overnight, it also pays a higher interest than Bills that have a far longer maturity; Bills which when if sold move the market and may result in capital losses.
Indeed, as the WSJ notes, recently, yields on ultra-short-dated bills have been climbing, in part because the U.S. Treasury Department has issued more of them. The drop in price has reversed the premium demanded last year when the bills were in tight supply. But the rate on the foreign repo pool remains higher than the rate on one-month bills and the domestic repo program.
What also explains this drop in price is that as foreign institutions increasingly use the Fed's facility, they move some of their dollars out of Treasurys and into the facility, the price of Treasurys falls and the yield rises.
As expected, according to ICAP's Lou Crandall, "much of the recent activity can be explained by Japanese officials liquidating U.S. Treasury notes and parking the proceeds in the foreign facility, judging from the changing reserve assets reported by Japanese authorities."
Others agree: "Peter Yi, who oversees about $230 billion of short-term fixed income products at Northern Trust Asset Management, said central bank’s use of the foreign repo pool has been contributing to higher Treasury bill rates."
And of course, if indeed the Fed is paying a premium to comparably risky securities, then there is no question why foreign central banks would be rushing into the safety of the printer of the world's reserve currency.
The question is why is the Fed effectively allowing this arbitrage, one which reduces foreign demand for short-term securities, in the process boosting their yield, while providing what amounts to yet another handout to offshore entities.
Recall that as we first reported in 2011, it was the Fed's generous payment of interest on excess reserves to foreign commercial banks that provided a big boost to those same deeply insolvent banks, who had parked hudnreds of billions in excess reserves with the Fed during QE1, 2 and 3, which incidentally is the Fed's own money created out of thin air.
In fact, according to the latest Fed data, foreign banks remain the single biggest beneficiary of the Fed's generous excess reserve policy, with some $1.1 trillion in reserves - more than either large or small domestic commercial banks - parked at the Fed belonging to foreign commercial banks: these reserves now collect a rate of 0.50% per year, a rate which is set to rise with every incremental rate hike.
While it is debatable if the billions in interest the Fed paid to foreign banks was equivalent to a slow-motion cash bailout (one set to increase), what is not debatable is that the same Fed which for 7 years provide generous funding to offshore commercial banks, is now granting foreign central banks the same arbitrage privilege, one which worst of all, is almost entirely shrouded in secrecy.
Perhaps during the next congressional testimony, instead of populist pandering, the Fed can ask Janet Yellen just why the Federal Reserve is making its reverse repo facility be a more attractive "investment" for foreign central banks than the ultra short-term securities issued by the Treasury of the world's reserve currency. In effect, the Fed has made its own "product offering" a more attractive investment than the government which it, by definition, is supposed to serve.
And finally one last question: if U.S. citizen savers get a 0.0% interest rate courtesy of the Fed despite the Fed's rate hike, why are foreign central banks getting 0.35% from the Fed?