Last week, the Federal Reserve announced that effective Monday, September 22, it was revising the terms of its Overnight Reverse Repo Agreements. (See our Sept. 18 "Link of the Day" for more details.) In short, each eligible counterparty will now be limited to one bid of up to $30 billion per day, an increase from the current $10 billion per-counterparty maximum bid limit, and each operation will be subject to an overall size limit of $300 billion. Money fund strategists say the changes will have a negative effect on MMFs. In his most recent Short Duration Strategy newsletter, Citi Research's Vikram Rai, who also spoke yesterday at our European Money Fund Symposium in London, forecasts rough weather ahead for money markets.
He says, "The aggregate cap of $300 billion spooked money market investors given that ON RRP usage has reached as high as $339 billion during the last quarter end and investors, quite rightfully, are worried that U.S. money markets rates will dip lower. Essentially, during quarter ends, dealers typically pull back from the repo market to shrink their balance sheets and cash that doesn't get placed with the Fed (on days that bids for the Fed's reverse repos exceed $300 billion, the Fed Bank of New York would use a bidding process where the lowest rates submitted are accepted first until the cap is reached) will make its way into the asset scarce money fund sector and put further downward pressure on yields."
JP Morgan's Alex Roever discusses the "somewhat disappointing" outcomes from the September FOMC meeting for money markets in his weekly market commentary. "The release of the Fed's exit principles and revisions to the terms of the Fed's overnight reverse repo facility (RRP), while not surprising, could make it considerably more challenging for money market funds (MMFs) to find a home for their cash going forward, particularly through this upcoming quarter-end. As of 9/18, there was $2.3tn of assets in MMFs $1.4tn in prime funds and $0.9tn in government funds)."
He says, "Already we've seen accounts actively bidding on CP/CDs with maturities in early October or early January to help them get invested through quarter-end/year-end. In the land of bills, supply is even scarcer. Typical quarter-end technicals and changes to the Fed RRP facility have now pushed 1-3m bills into negative territory. Unfortunately, we still have slightly more than a week to go before actual quarter-end. During this time, the supply and demand imbalance in the money markets will only intensify, pressuring overall rates to move towards to zero or even into slightly negative territory."
Roever continues, "Even capped, ON RRP will drain reserves and support a higher funds rate. During normalization the Committee intends to use the ON RRP facility and other supplementary tools as needed to help control the Federal funds rate, adding that it "will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate." The Committee's statement was not especially surprising considering the tone of the ON RRP comments in the June and July minutes."
Roever writes, "However, shortly after the FOMC meeting the NY Fed -- which administers the ON RRP program -- released a statement outlining substantial changes to the program, effective September 22. Among the changes is the introduction of an aggregate facility cap of $300bn, the introduction of a daily Dutch-auction process for determining both the overall facility rate and allotments among counterparties, and an increase in the individual counterparty cap to $30bn from $10bn. Exhibit 3 compares the new ON RRP facility terms with the prior terms. Relative to its prior configuration, the changes adopted by the Fed should contribute to higher average usage of the ON RRP -- up to the cap."
Further, he adds, "Changes to the ON RRP will depress yields on T-bills and GC repo.... Before the ON RRP changes were announced this week, we had speculated demand for the program at the end of this quarter could approach $500bn. With the new program size cap, usage obviously won't reach this level. But interestingly the increase in individual counterparty cap to $30bn will probably increase the intensity of demand for ON RRP by allowing some of the larger counterparties to take bigger bites. If the overall cap was not in place, but the user cap had been $30bn instead of $10bn, and the offer rate fixed at 5bp, we estimate overall demand for the ON RRP at September 30 could have easily reached $400bn just from the MMF counterparties."
JPM also comments, "Now, with the overall cap and the higher counterparty limit, we think average daily demand for ON RRP use will rise and test the overall program limit at quarter-ends and other low liquidity periods. As this happens, the new Dutch auction format should push down yields on the ON RRP, and increase demand for alternative assets like GC repo, t-bills and similar assets, pushing down these yields to a point. As money market yields approach 0bp, fund managers will be inclined to leave more balances at custodial banks, basically earning nothing. Although custodians have generally been willing bear these balances, regulations like LCR and SLR make doing so costly. As a result we may see custodians to more actively pass on costs to clients via higher fees and leading investors to choose between paying fees or accepting even lower market-based yields."
He concludes, "While the Fed's future plans for the ON RRP may help lift the Funds rate, the new format poses problems for other short term rates. Money market investors are disappointed, as they had hoped that the ON RRP would be source of reliable supply at a time when regulatory changes are both leading banks to push cash from deposits into the money markets and decreasing the availability of investible bank liabilities. The net result is there is a growing glut of cash in the money markets that doesn't have a good place to go. As the ON RRP is still technically in a testing phase, it is possible the Fed could reconsider its overall program cap, but given the tone of the exit "Principles" it seems unlikely for now."
Garrett Sloan, director, Well Fargo Securities, in his commentary, said the latest move by the Fed draws an interesting analogy <b:>`_. "There is a great commercial on television that shows two kids standing over a seemingly lifeless opossum. We later find out that their dad bought the animal as a pet, as it was cheaper than buying a dog. It turns out that the opossum is not lifeless but is just playing dead. As the kids poke and nudge the animal progressively harder, it eventually reacts with a hiss. The New York Federal Reserve is acting towards money market investors in a manner that I might compare to a child poking an animal with a stick. For those of you following along, the stick is the reverse repo facility and yes, money market participants are opossums (which is probably not too far off, really). This quarter-end we may see whether this last poke is the one that wakes up the animal with a startling hiss."
Continues Sloan, "Under a fixed-rate full-allotment operational system, the RRP offering level (currently 0.05 percent) represented an almost de-facto hard floor that would shift, along with its companion policy rate the Interest on Excess Reserves, the general level of money market rates. Under the revised operational system, the $300 billion cap creates a situation, albeit currently rare, where strong demand for access to the Fed's balance sheet (i.e. quarter-end or during times of market stress) could force money market funds and other counterparties to bid well below the reverse repo offering rate (currently 0.05 percent). In fact, in its statement the New York Fed has approved transactions with negative rates, indicating its understanding of the potential ramifications of this policy shift."
He concludes, "The Fed has attempted to reassure us that this is just another operational exercise, and we believe this is likely the case. However, the trends in overall average daily usage of the RRP suggest that as dealers shrink balance sheets and repo availability to cope with regulatory changes (even though compliance for many of the reforms remains months/years away), the squeeze for collateral is growing and the $300 billion cap that has heretofore been an anomaly could actually become a regularity. In that situation, the lower bound for the Fed's policy implementation channel (i.e. the RRP) could become rather sloppy and we might expect to see further revisions to the RRP cap as it tries to walk the fine line between moral hazard and market volatility."
