Federated Investors writes in latest "Month in Cash," "Pay attention to what the Fed does, not says." The article, written by Money Market CIO Deborah Cunningham, explains, "Last month, Fed Chair Janet Yellen put on her academic mortarboard and delivered a history lesson. Last week, she traded it for a Sherlock Holmes houndstooth hat for "The Case of the Missing Inflation": "The shortfall in inflation is a mystery," she said in a speech in Ohio." We excerpt from her latest piece, and also review a blog on Tri-Party repo from the NY Fed, below.

Cunningham's update explains, "She and other economists may be frustrated that things aren't following their equations, but they seem to be pretty comfortable that inflation is either at or near enough to their target to keep tightening. In any case, cash managers tend to look at what Federal Reserve policymakers do, not what they say. With four rate hikes in the last two years, and a fifth likely coming in December, it would seem the Federal Open Market Committee (FOMC) participants think they won't need a sleuth with a magnifying glass to find rising prices and wages."

She explains, "If we needed another clue to their thinking, the Fed officially announced that in October -- today, actually -- it will begin to pare its massive balance sheet, a sign that extraordinary accommodation is coming to an end. All cash managers and nearly everyone else in the industry expected this move -- it was just a matter of when it would happen -- so there wasn't a negative market reaction. We can't help but wondering if Yellen factored in her legacy with the start of tapering. With this, she will get credit for reversing nearly all of the post-recession monetary policies. But it also was just time to start normalization."

Federated's piece says, "Meanwhile, the Fed's economic projections released at the last policy meeting suggest another 25 basis-point hike is on the table this year. We have thought so for some time now, and the market has returned to that opinion after doubting it recently. There will be some noise, both from the aftermath of the destructive hurricanes and the postponed debate over the federal budget and debt ceiling, but that shouldn't make a major difference. We already have seen more value come back into the yield curve: a slight steepening that has made 3- and 6-month fixed-rate paper attractive along with floaters."

It adds, "We have therefore kept the weighted average maturity (WAM) of our products at last month's ranges: 40-50 days for prime and 30-40 days for government and municipal funds, with most lying in the middle of these target ranges. Industry-wide, prime products tend to more responsive than bank deposits to rising rates because they trade the London interbank offered rate (Libor), which historically responds to Fed hikes quicker. It is important to remember that money market funds provide a market rate, not an administrative one chosen by a bank or similar institution."

In other news, the Federal Reserve Bank of New York's Liberty Street Economics blog features the brief, "Excess Funding Capacity in Tri-Party Repo." They write, "Security dealers sometimes enter into tri-party repo contracts to fund one class of securities with the expectation they will wind up settling the contract with higher quality securities. This strategy is costly to dealers because they could have borrowed funds at lower rates had they agreed to use the higher-quality securities at the outset. So why do dealers do this? Why obtain or arrange excess funding for the initial asset class? In this post, we discuss possible rationales for an excess funding strategy and measure the extent of excess funding capacity in the tri-party repo market. In a second post, we examine the maturities of repos used to generate excess funding capacity and estimate the costs of this strategy."

They explain, "A repo is effectively a collateralized loan, structured as a paired sale and future repurchase of securities at specified terms. The difference between the future and current price of the securities determines an implied interest rate, which is typically used to price the repo. The interest or repo rates are typically lower the higher the quality (in terms of risk and liquidity) of the securities posted as collateral (for example, see the tri-party repo rates posted by the Bank of New York Mellon). This feature makes generating excess funding capacity costly, because dealers negotiate a repo rate based on lower-quality collateral, but end up allocating higher-quality securities."

The piece tells us, "Another important feature of repos is the haircut, which represents the additional collateral available to the lender to cover losses in the event of a counterparty default. Unlike with rates, the haircut for a given trade will depend on the quality of the eligible securities allocated at settlement; if a dealer posts better-than-necessary collateral to a repo, the required haircut declines accordingly but the negotiated interest rate on the cash does not change."

It explains, "A dealer might maintain excess funding capacity for two reasons. First, it may be difficult to find investors willing to provide funding against certain asset classes. When such an investor is found, the dealer might negotiate more funding than necessary to ensure funding in the future. Second, a dealer may want excess capacity as a buffer in times of crisis when investors may reduce the amount of funding they are willing to provide against particular asset classes. Having excess capacity gives a dealer time to find other investors or to de-lever. In fact, some dealers consider excess funding capacity in their internal stress tests."

The blog states, "Using confidential, daily data covering March 2017, we compute dealers' excess funding capacity in tri-party repo, where U.S. dealers obtain a large part of their secured funding.... Our data reveal both the lowest-quality asset class from which securities can be used to fulfill the obligations of a repo and the asset class of the securities actually allocated at settlement. We define excess funding capacity to be the amount of a repo backed by higher-than-necessary quality collateral."

Finally, the NY Fed says in its "Takeaways," "In the tri-party repo market, we find that dealers seek excess funding capacity, especially for agency MBS and equities securities. This fact suggests that dealers value the option of having funding available for such asset classes in the future. In our next post, we examine the repos generating excess funding capacity in more detail and estimate how much this strategy costs dealers."

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