Strategists on Fed Funds Rate Changes
Citi Research strategist Andrew Hollenhorst commented on the recent news of future changes to the Fed funds rate in his "Short-End Notes." He writes, "[Last] Monday, the Federal Reserve announced more details of the changes it plans to make to the calculation of the fed funds effective rate. The changes had been expected for some time and we expect implementation is approximately a year away. In our view the change in calculation will bias fed effective 1-2bp higher. Separately, the Fed is introducing a new overnight bank funding rate (OBFR) that we expect to average 1-2bp below current fed effective." He asks, "Why might Fed Effective move higher? The brokered fed funds market is dominated by Federal Home Loan Banks (FHLBs) that do not earn IOER lending cash to banks that do earn IOER. In Q4 2012 these transactions made up about 75% of an at that time $60 billion market.... Given their apparent size in the brokered market, it seems plausible that a substantial fraction of FHLB transactions are brokered. If this is the case, adding more bilateral transactions means adding non-FHLB transactions leading to a higher fed effective. Why might Fed Effective move lower? On the other hand, a case can be made that lower credit quality banks that borrow at higher rates are more likely to transact through brokers than bilaterally.... On balance, we think the arguments for higher fed effective are stronger than those for lower." Barclays money market strategist Joseph Abate also issued commentary on the NY Fed's future changes to the federal funds rate. He writes, "Earlier this week, the New York Federal Reserve announced plans to change the way the effective fed funds rate is calculated. Alongside the re-calculation -- which will begin in about a year -- the Fed will introduce a new overnight bank funding rate. The current effective fed funds rate is based on trades executed through brokers. An expanded rate will include bilateral or bank-to-bank transactions. But it is not clear if or how much brokered and bank-to-bank fed funds trades differ. GSE preferences for one channel over the other are critical for determining any potential rate bias. The Fed's proposed overnight bank funding rate will capture a wider range of unsecured overnight bank financing transactions than fed funds. Ultimately, we think the change in coverage of the effective funds rate and the existence of any bias may be overwhelmed by the recent RRP expansion and the Fed's lift-off later this year."
