Fed Repo Facilities: What’s Next

The Fed’s Interest rate on Required Reserves penalty rate today is 0.50. The Fed’s Interest Rate on Excess Reserves penalty is 0.50 today. The spread between the stasis 0.38 Fed Funds rate and headline is 12 bps, 0.38 to 0.50. Libor is stagnant at 0.37 and 13 BPS to headline. The 1 month yield trades 0.28, 0.30 for the 3 month and 0.42 for the 6 month. The noted point are miniscule gaps created not only since the 2008 crisis but since the 1971 free float. Traditional central bank management functions as market facilitators were add and subtract liquidity as needed inside a full basis point and far larger gaps.

Yellen views market fluctuations as disturbances because volatility detracts from ability to manage and control the Fed Funds rate. Yellen needed guarantees to ensure a floor would be created if she raised the Fed Funds rate. She found it in the newly created 2015 program of the Overnight Reverse Repurchase Agreement and the Reverse Repurchase Agreement. Most important is the Overnight Reverse Repurchase Agreement because that rate is fixed with a purpose to “Steer the overnight rate.” Steer means hold Fed Funds and lower market rates inside small channels to protect the Fed Funds Rate. Yellen’s Monetary Policy as all central banks is stated in the favorite word mentioned constantly in Fed Minutes: Monetary Control and communicated through the guided message. Control of Fed Funds through both Repo facilities allows Yellen to reinvest the $2 trillion available in the Fed’s System Open Market Account since Repo facilities were created for Treasuries. Borrowings are also allowed at far lower rates.

The original program in the run up to raise Fed Funds was steer Fed Funds through Interest on Required Reserves and Interest on Excess Reserves. The deal was IOER provided the sell rate while IORR provided a buy rate floor inside a 5 BPS channel but all activities done below Fed Funds rates to lend support. Imagine if Yellen raised headline then market disaster struck and Fed Funds traded above Headline or a run on banks occurred. That situation is not economically good especially when Yellen raised into a questionable economy. Yellen accomplished her goals in this program as sufficient distance exists between Fed Funds and headline. Fed Funds steer was as much the object as guide monies in small channels. It explains why M1 Velocities are at historic lows and why Yellen is able to remain a holder and re investor of stimulus bond purchases.

As IORR and IOER are both at 0.50 and Fed Funds is protected, enter Overnight Reverse Repo Facility and Reverse Repo Purchase facility. ONRRP serves as the sell point at the top of the channel and its rate is fixed while the Reverse Repo serves as the floor. Today, $52 billion Treasuries went through this facility at an interest rate of 0.25. Yesterday, $34 billion went through at 0.25, Friday February 12th, $35 billion went through at 0.25. The last 25 transaction all involved Treasuries since its a %300 billion per day Treasuries only facility and traveled through at 0.25. Both facilities not only involve Yellen Treasuries but corporate and bank borrowers access far below market rates in a buy low, sell high scenario.

Further management proposals by the Fed is to reduce the cap on the ONRRP. One proposal is to widen the spread between interest on reserves and the sell rate on ONRRP. What’s obvious is the cap is going lower, how the Fed finally derives the lower cap is unknown since the current system remains in proposal stages.

The goal of ONRRP and RRP is to steer Fed Funds, money, velocities and Treasuries into the small 5 BPS channel as was the case in the IOR and IOER. What this means is creation of a lower financing rate for the Fed, banks and major companies, especially major companies. Major companies largely finance operations through both Treasuries and Fed Funds. Companies doing business across borders employ interest rate swaps.

What ONRRP means for Fed Funds is no rush to raise as long as banks and companies finance and turn profits at lower levels of interest. A rate borrowed at 0.25 can reinvest anywhere along the yield curve and not move yields. Creates stability and tales away volatility. If velocities in M1 remains low especially at current and historic 5.9 lows, Inflation over time may reach the 2% target. But the Fed speaks to Inflation in medium terms but never defined. If the economy muddles along slowly at 1 and 2% GDP without implosions then payoffs to borrowers and ONRRP financiers remains viable. What this means for markets is volatility ceases over time as interest rates compress. Globally, lower the ONRRP cap moves interest rates closer to those 6 negative interest rate nations. As negative interest rate nations are on the path towards an economic rebuild, possibly ONRRP is the United States facility to economically rebuild.

Brian Twomey, Inside the Currency Market, btwomey.com