Last week we reported on the Federal Reserve Bank of New York's decision to expand its list of Reverse Repo counterparties. (See Crane Data's Nov. 13 News, "New York Federal Reserve Looks to Expand RRP Repo Counterparties".) Since then, several money market strategists have also offered their take, explaining how the involvement of Government Sponsored Entities, particularly the Federal Home Loan Banks (FHLBs) could impact the Fed funds and repo rates. (We noted that all of the 25 largest money fund managers are already counterparties, with the exceptions of: Franklin, American Funds, SEI, HSBC and Reich & Tang.)
In his November 13 commentary, Garrett Sloan, fixed income market strategist at Wells Fargo Securities, says "Judging from the current counterparty list it would appear that there is one sub-group from whom they would like to see more RRP activity, specifically the GSEs. Why is that? Well, when it comes to trading in the Fed funds market, the GSEs are the last issuers standing, with most banks opting to park cash at the Fed. Given that the FOMC has said it would like to continue using the Fed funds rate as its primary tool for monetary policy transmission, the level of the Fed funds rate is quite important. Without more GSE participation in the reverse repo program, the Fed funds rate could remain stubbornly sticky even as the Fed increases RRP and IOER policy rates."
He adds, "As such, more RRP participation is important if the Fed wishes to keep the Fed funds rate moving in a stable range along with the RRP and IOER. If there is not more GSE participation, the soft floor being set by the RRP will have less of an impact on the Fed funds rate, as the alternative for non-participating GSEs would be 0 basis points. Currently, only the FHLBs of Boston, Chicago, Cincinnati, and Des Moines, along with Fannie Mae and Freddie Mac are participants. Non-participants include Farm Credit along with the FHLBs of San Francisco, Seattle, Topeka, Dallas, Atlanta, Indianapolis, Pittsburgh, and New York. Recently, the Fed lowered the RRP rate to 3 basis points, and on Monday it [increased] the rate to 7 basis points, then 10 basis points on December 1 through December 12. GSE applications for RRP participation are due November 24, one week before the Fed tests the RRP at 10 basis points. Even though the latest wave of counterparties will not be added until Q1 2015, we could see the Fed funds rate push higher from the current 9-basis point level as the RRP moves to 10."
Barclays money market strategist Joseph Abate in his "Weekly Money Market Update," comments, "In effect, the Fed is telling potential counterparties to join now or lose the opportunity forever, as the Fed plans to terminate the program once it is no longer needed to control the fed funds rate. We do not think that there are many eligible non-participants left to take up the Fed's invitation. That said, including some of those that are some of those that are left may have a significant effect on the effective fed funds rate."
Abate explained, "Currently, these institutions must choose between leaving their cash uninvested at the Federal Reserve to earn 0% or selling it into the Fed funds market for a slightly higher rate. Their ability to sell cash into the fed funds market, however, is limited by the fact that buyers in this market (banks) are already long cash and have little need for additional funding.... With few alternative investments for their cash, the FHLBs have become price takers in the fed funds market. From the perspective of policymakers, however, their ability to establish a hard interest rate floor under the policy rate is constrained to the extent that the FHLBs are selling cash into the market at rates below the RRP rate but above 0%."
Further, he comments, "Markets initially interpreted the expansion of the RRP counterparty list to mean that the eight remaining FHLBs would abandon the Fed funds market completely for the RRP program. And this would have two significant effects. First, it would (obviously) shrink the size of the fed funds market dramatically, and second, it would remove nearly all of the highest quality/low rate borrowers from the market. All things equal, both effects would bias the effective funds rate higher. We think the second of these effects is particularly significant because of the distribution of borrowers in the fed funds market."
Abate continues, "By giving the FHLBs the chance to earn roughly the same amount of yield in a riskless trade with the Fed at the RRP rate as opposed to taking on unsecured bank risk, the Fed should theoretically remove their willingness to sell cash in the fed funds market at or below the RRP rate. In effect, the Fed could harden the interest rate floor under the RRP rate, but at the cost of a significant reduction in volume in the market of its principal policy lever. Although we generally agree with this line of reasoning, it not entirely obvious that all of the remaining eight FHLBs would prefer the RRP program to the fed funds market. In fact, the FHLBs have a longstanding aversion to tri-party repo that stems from when the cash from unwinding the trade is returned to their coffers. Unlike the fed funds market, which allows for the early return of cash, in the tri-party repo market, cash is typically not returned until 3.30pm or so.... Thus, the key decision that the FHLBs will need to make will be to figure out what spread between the Fed funds that they sell and the RRP rate (which is a tri-party transaction) they will need to earn to compensate for the absence of early-return cash."
He tells us, "Indeed, it is possible that the current fed funds clearing rates that they face with large money center banks of between 4 and, say, 6 to 7bp leave them indifferent to the Fed RRP facility. In that case, the volume of fed funds transactions might not decline and, importantly, the bulk of the market volume would continue to be transacted at the lower end of the rate distribution."
And how would this impact the repo market? Finally, Abate says, "The outlook for repo rates is less clear. On the one hand, it is possible that hardening the floor under the fed funds rate (and potentially even increasing it if volumes traded decline) might drag repo rates higher.... But on the other hand, it is possible that collateral rate could decline. As a result, while we generally think the inclusion of the eight non-participating FHLBs in the RRP will harden the floor under the fed funds rate, it is not obvious how much higher the effective fed funds rate might trade. Likewise, while we expect that repo rates might be biased lower, this effect, too, is not clear cut."
Finally, in his recent "Short End Notes” commentary, Citi Research money market strategist Andrew Hollenhorst concludes, "Based on filings from Q3 2014 it looks like at least 5 or 6 of the remaining FHLBs have been maintaining $1bln in cash in repo, one of the requirements for these institutions to become RRP counterparties. The addition of these FHLBs to RRP is most significant for the Fed funds market as the majority of activity in this market consists of FHLBs, which do not earn 25bp IOER, lending cash at low rates to banks that do earn IOER. To the extent FHLBs shift this cash to Fed RRP, the fed funds effective average rate will move higher as it will incorporate less low rate transactions."
