Federal Overnight Reserve Repurchase Repo and Fed Funds Implications for 2015
When the Federal Reserve began to pay interest against bank deposits was first granted in 2006 when the United States Congress passed the Financial Services Regulatory Relief Act of 2006. The legislative start date was 2011 but the mortgage collapse caused a deep conundrum in housing and other markets in 2008 so Congress then passed the Emergency Economic Stabilization Act of 2008 to begin immediately to pay interest on required reserves for the third time in 50 years. Prior to 2008, the Fed paid interest on required reserves for two months total in 2001 at the time of 9/11 and the beginning of the 2007 recession. Two purposes existed to pay interest on required deposited reserves: to maintain the Fed Effective Funds rate close to target and in range and prevent Fed Funds from trading at 0 or worse trade in negative territory as is the case in regards to Eonia in Europe despite ECB ability to pay required interest reserves since 1999. The other example is Sweden’s Repo Rate currently trades at 0 while the BOE was granted legislative capability to pay interest on required reserves since 2009 to offer worldwide context.
The second aspect to the 2008 legislation is the Fed’s ability to pay and adjust interest on excess reserves but this new Fed “tool” was little known and employed yet would become an interesting foresight as excess reserves and the velocity of the Fed’s balance sheet in relation to the historic monetary base skyrocked from 2008 / 2009 onwards when various Tarp facilities were introduced to provide liquidity to the banking system. Required Reserves for example averaged about $100 billion during the first six months of 2012 while excess reserves averaged $1.5 trillion. ( SF Fed ). Since the supply of Treasury bond credits is as good as demand, the Fed faced a Liquidity Trap where monetary policy fails to stimulate demand and interest rates are at 0. So comes the time to soak up the excess supply by introduction of new Term Deposit Facilities.
The first facility is the Fixed Rate Overnight Reverse Repurchase Agreement ( ON RRP) while the second is the Interest on Excess Reserves or IOER. The ON RRP is the primary tool to move Fed Funds into target ranges and create a floor for Fed Funds by setting Bid rates for Treasury bonds only while the IOER would serve as offer rates but both rates held within a small channel between 0 – 5 basis points or 0 – 0.05. ( Sept-Oct Minutes). Therefore Bid rates must be below offer rates at 0.05. The further proposal since both facilities are new and hardly in implementation stages is to offer a maximum Bid rate of 10 basis points. Further ON RRP proposals is to vary rates by auction, by a schedule and vary the spread between the ON RRP and interest paid on excess reserves. Both facilities are for Treasury bonds only with a maximum market of $300 billion per day and limited to 1 bid per $30 million, per counter party, per day. The $30 billion per day was originally $10 and changed with September’s minutes by a vote of the Board.
To place 0.05 in context, Fed Funds closed on a monthly average basis at 0.09 in 11 of the past 17 months and in 9 of the past 12 months. Fed funds closed above 0.09 twice in the last 19 months at 0.10 and 0.11. Last time Fed Funds closed at 0.20 was 55 and 54 months ago. The highest monthly close at 0.22 was seen 5 1/.2 years ago specifically 69 months. The Fed Funds 2 year average is found at 0.10, 5 year average at 0.12 and 10 year average is found at 1.62. Essentially, the entire Repo market is found beween Bids from 0 – 0.05 to Offer Rates from 0.05 – 0.10, 0.12.
The ON RRP operates as any Repurchase Agreement. The NY Fed sells bonds to approved counterparties with agreement to repurchase at a later date. The sale minus the repurchase price equals the rate of interest paid by the Fed on cash invested by the counterparty, termed the Repo Rate. Fed deposits are then limited to Reverse Repos. Current operations are facilitated from 12:45 pm – 1:15 pm Eastern time and rates of interet on excesees are reported on the Federal Reserve’s website on H3 every Thursday at 4:30 pm Eastern time. Trade durations are overnight with a same day settlement.
Fed examples ( NY FED). Assume 5 Bids at $5 billion each at varying rates between 1- 5 basis points. Bids were under the $300 billion market maximum and under 5 basis point limits so Bids would be granted. Assume 20 Bids at $20 billion with 4 Bids submitted at 1, 2, 3, 4 and 5 basis points. Total Bids exceed the $300 billion maximum at $400 billion so Bids at 1, 2 and 3 are granted and the 4 basis point bid is awarded 75% of the bid or $15 billion while the 5 basis point Bid is not awarded to allow the market to maintain its $300 billion Maximum.
Repurchase Agreement markets accompany a Stopout Rate and its the rate ” by evaluaton of total Bid Rates in ascending order by bids up to the point where total quantity of offers equals overall size limits. The purpose of the Stopout rate is to control the $300 billion market maximum. If sum of bids is greater than size limits, awards are allocated using a single price auction based on the Stopout Rate while bids below the Stopout Rate are granted on a pro rata basis.”
To understand current debt, the Congressional Budget Office reports released July 2014 states as a % of GDP, federal debt held by the public is 4.3 times greater than federal revenues. For 2014, Federal Spending was 20.4% Vs revenues of 17.6% , a minus 2.8% gap. Historic 40 year average revenues were always 17% of GDP but projected at 19% by 2039. But debt on current paths equates to 106% of GDP by 2039. Interest payments in 2014 was $231 billion or 1.3% of GDP and projected $799 billion in 2024 or 3.9% of GDP. Traditional insolvency methodology occurrs when Interest on Debt approaches upper teens. By end 2008, Fed debt held by the public was 39% of GDP and close to decades long average but end 2014 is expected to 74% of GDP and 2 times more than 2007 and higher than any year since 1950.
Deficits caused debt growth, projected at 74% of GDP or $506 Billion by end 2014. In 2009, deficits were 10% of GDP below the 40 year average and 2.9% for 2014 but $170 billion lower than 2013. Spending is expected to rise 2% to $3.5 trillion.
The all important Debt to Tax Ratio was 3.6% in 2009 and now hovers at + 4%. From 1980 – 2008, the Debt to Tax Ratio was 2% and held steady. If by 2039 debt to GDP at 106% with 19% revenues equates to a whopping Debt to Tax Ratio of 5.5%. Current Debt to Tax Ratio at 4% is the highest since the 1940’s while lows at 1.5% was seen in the 1970’s.
November 2014 monthly data based on Treasury information revealed Bills outstanding and held by the public comprised in millions 1, 438, 321 Vs 1, 626, 460 in October 2012. Notes in November 2014 comprised 8,182, 673 Vs 7, 320, 862 in October 2012. Bonds in November 2014 comprised 1, 563, 086 Vs 1, 296, 664 in October 2012. Total Fed holdings in millions: 2, 461, 625 as of November 2014. Bonds and Notes comprise the largest Fed holdings and are the prime tradeable instruments in Repo markets due to greater price fluctuations and ability to profit. Since Repo facilities trade durations are overnight, banks and money markets funds earn ability to profit from a higher overnight rate than what could be earned from a 1 month Treasury bill at current 0.02, 3 month Treasury at 0.01 and 6 month Bill at 0.08.
The Term Repo Facilities are expected to end by January 2015 particularly outlined by Fisher in recent speeches. A personal read of past Fed minutes reveals in my estimation the methodology to raise the Fed Funds rate would occur on a gradual scale by raising the Bid and Offer ranges within ON RRP and IOER. Once ranges were raised to acceptable levels to create a sufficient floor, a rate rise would occur imminently. But this assumption assumes ON RRP and IOER remain as more than the experiment as intended because actual trading of loans must be seen on a longer term scale. It also assumes the Fed owns another facility to control the Fed Funds rate as a policy more than a market rate for the foreseeable future. If the facilities remain, the guide to a Fed Funds hike should be found when Bid Rates are raised above the 5 year average at 0.12 but ultimately to 0.25 as is the present rate. A new floor is then created. The actual Fed Funds rate would be found on a 1/4 point rise between 0.50 – 1.62.
Published FX Trader Magazine
Brian Twomey, Inside the Currency Market, btwomey.com