Wall Street Confused by Fed’s Choice to Adjust Key Tool
The Federal Reserve is anticipated to decrease the rate on one of its tools designed to help manage the primary policy benchmark. However, some stakeholders on Wall Street question the reasoning behind this potential change.
A majority of strategists believe that the Fed will reduce the offering rate on its overnight reverse repo facility (RRP) by 5 basis points, possibly as soon as next week, coinciding with expectations of a quarter-point cut to the benchmark rate. The current RRP rate stands at 4.55%, which is five basis points above the lower limit of the Fed’s target range of 4.5% to 4.75%.
ADVERTISEMENT
CONTINUE READING BELOW
These expectations come after policymakers indicated they recognize the benefits of a “technical adjustment” to the RRP rate, bringing it in line with the lower end of the target range for the federal funds rate, as noted in the minutes from the November meeting. While such a change could generate downward pressure on money market rates, it may also influence the amount of funds held at the Fed facility, prompting discussions on Wall Street regarding the advantages of such a shift.
Since their peak in December 2022, balances at the facility—a measure of excess liquidity in the financial ecosystem—have decreased by roughly $2.4 trillion, although the rate of decline has slowed down recently. In the Wall Street arena, the total cash held at the RRP has long been viewed as a valuable indicator as the central bank continues to reduce its balance sheet through a process referred to as quantitative tightening.
Barclays Plc considers aligning the RRP with the lower limit to be a “purely technical” adjustment, based on insights from the minutes. However, firms like Bank of America, TD Securities, and Citigroup are puzzled as to why such a policy change is necessary now when approximately $175 billion is currently parked at the RRP. Furthermore, usage is expected to rise organically in the first half of 2025 due to anticipated reductions in Treasury bill supply resulting from the debt ceiling, which may drive counterparties to park more cash at the RRP.
The last alteration in the tools occurred in June 2021 when the rate on the RRP facility was raised in response to an abundance of dollars in short-term funding markets that greatly exceeded the supply of investable securities, putting downward pressure on front-end rates, even as the Fed’s key benchmark remained stable. At that time, $521 billion was kept tucked away in the overnight RRP facility.
Expert Insights
Wrightson ICAP (Lou Crandall, December 9 report)
- Wrightson now forecasts that the Fed will cut the RRP rate by 5 basis points either next week or during the January meeting, despite Crandall’s earlier belief that such an adjustment was “likely still some months away.”
- The timing of the adjustment may hinge on the Fed’s upcoming policy actions, as the central bank may opt to separate the rate cut from the technical adjustment.
- They do not foresee significant ripple effects on unsecured rates, primarily because the fed funds market predominantly reflects overnight cash that Federal Home Loan Banks temporarily keep at foreign institutions for liquidity needs. The arbitrage spread has remained stable at 7 basis points for most of the last three years, and an unchanged spread on fed funds-interest on reserve balances is anticipated.
- The firm predicts that both the Secured Overnight Financing Rate and Tri-Party General Collateral Rate will decline by 4 basis points relative to the Fed’s target range but acknowledges the possibility of a full pass-through of 5 basis points.
Morgan Stanley (Martin Tobias, December 6 report)
- Analysts expect the RRP rate to be pared by 5 basis points at the December meeting, positioning the adjustment as a means of realigning the rate with the lower bound of the federal funds target range that existed at the inception of the facility as a monetary policy instrument.
- The reference to a technical adjustment in the November FOMC minutes, along with a staff briefing focusing on balance-sheet management, indicates that quantitative tightening and the functioning of money markets are high priorities.
- It is anticipated that the fed funds rate will remain 8 basis points above the lower bound—currently at 4.5%—as it is unlikely the fed funds volumes will grow sufficiently to create downward pressure on fed funds.
Citigroup (Jason Williams, December 6 report)
ADVERTISEMENT:
CONTINUE READING BELOW
- Estimating when the Fed might implement an RRP adjustment is complicated, as it is difficult to gauge the need for it, according to Williams. The Fed may not need to adjust the RRP rate until the January meeting (or even later into 2025), particularly if the debt ceiling is a primary concern.
- If the market had anticipated a December implementation, the SOFR/fed funds Dec/Jan futures curve would have steepened more significantly. This would affect roughly 10 days this month and about 25 days in January; the futures curve should have steepened by 0.4 basis points for each 1 basis point movement in SOFR/fed funds, but this steepening did not occur.
- Whenever the Fed chooses to reduce the RRP rate by 5 basis points, tri-party repo rates are expected to decline by the same margin, along with bilateral rates, although a move of only 3 to 4 basis points may occur as dealers might take an extra basis point or two. Fed funds are expected to continue trading 7 basis points below the interest on reserve balances (IORB) rate.
Bank of America (Mark Cabana, December 5 remarks)
- There is not a strong conviction that the Fed will adjust the RRP rate in December — although it seems likely — as “the reasoning behind the move is quite puzzling to us,” Cabana stated during a press call discussing BofA’s 2025 outlook.
- Should the Fed proceed with a 5 basis point adjustment to the RRP rate, it will decrease repo and T-bill rates, with the Secured Overnight Financing Rate dropping by the same amount.
JPMorgan Chase & Co. (Teresa Ho, Srini Ramaswamy, December 2 remarks)
- “Reducing the RRP rate by five basis points will effectively bring SOFR back into the middle of the target range,” remarked Ho during a media roundtable focused on its 2025 forecast.
- “It may be the case that lowering RRP rates won’t have much effect given the low balances at RRP, but a reduction in IORB could be beneficial,” Ramaswamy added.
TD Securities (Gennadiy Goldberg, December 2 report)
- The Fed’s inclination to reduce the offering rate on the RRP facility—potentially in December—might provide the central bank with a strategy to avert reserve shortfalls “for a while longer.”
- The firm still anticipates the Fed will halt its QT altogether by March 2025, considering the RRP adjustment to be a short-term measure.
- A 5 basis points drop in the RRP rate is expected, while interest on reserve balances will likely hold steady, resulting in a 5 basis point decline in SOFR and roughly a 4 basis point decrease in the fed funds rate; read more
Deutsche Bank (Steven Zeng, Matthew Raskin, Brian Lu, December 2 report)
- The forthcoming adjustment—likely in December—aims to address two objectives: easing upward pressure on money market rates, and facilitating a continued reduction of RRP balances.
- Repo rates should decline post-adjustment, with a “partial” pass-through to the effective rate on fed funds anticipated.
Barclays (Joseph Abate, Nov. 27 report)
- “The reasoning for decreasing the RRP rate is strictly technical,” Abate asserted. “It is intended to restore the rate to its pre-pandemic level at the bottom of the fed funds band.”
- The Fed is expected to keep the interest on reserve balances (IORB) rate unchanged at 4.65%, which will widen the gap between the two rates to 15 basis points.
- Overall, a 5 basis point reduction in the RRP rate is projected to lower all repo rates in a comparable manner, “but it is important to note that this reduction will not alter market fundamentals,” given that balance sheet capacity remains constrained and demand for all asset funding remains robust; read more
© 2024 Bloomberg
Stay updated with Moneyweb’s comprehensive finance and business news on WhatsApp here.