Citi Says Don't Fight the Fed Yet
Citi's Steve Kang writes in a new "Short-End Notes," "Don't fight the Fed yet." He explains, "We discussed the Fed's potential course of action and its market implications, from simple sterilization of reserves to a multi-floor system1 and a 'shadow' QE.2 What exactly, is the condition for the Fed to act? Technically, the Fed is not necessarily worried about the level of IOER/FF. Instead, they are worried about the correlation between IOER/FF and reserves, i.e. the slope of the FF demand curve. We have used Figure 2 repeatedly to show that the current correlation seems low enough for the Fed to hold tight for now, in our view. As the Fed has two competing objectives on their B/S – (1) achieve the minimal B/S and reserve amount while (2) keeping control of the FF market – the trajectory of the B/S hinges on the maximum slope (i.e. correlation between reserves to FF) that the Fed is comfortable with." Citi adds, "We continue to think the Fed is not comfortable going back to the corridor system (i.e. operating at the steep part of the FF demand curve) as they are not always on the drivers seats for reserves. However, it is possible that the demand curve can sufficiently flat for the Fed, even at FF>IOER. In other words, we are seeing more scenarios of the Fed continuing with the B/S normalization even with higher levels of FF. In Fed we trust, we like fading the market expectation of the Fed losing control of the fed funds and ending the normalization pre-maturely. We maintain tightening bias on FV OIS spreads."
