Fed: Addressing Repo Stress

Published on September 18, 2019
SGH Insight
First, the easiest quick fix to the ending stress would be a third downward tweak to the spread of the Interest on Excess Reserves rate over the bottom end of Fed Funds range by at least 5 basis points. So we assume it is almost certain the formal policy statement from the Federal Open Market committee will include an implementation note that the IOER will be cut by a larger 30 basis points, putting the rate at 1.80%, relative to the highly likely 25 basis point cut in the target range for federal funds to 1.75%-2%.
We are hesitant to fully buy into the argument of the expanded balance sheet being announced today. We do not hold any strong conviction one way or another on this front, but we would wonder whether the FOMC will be more inclined to address the short term funding stresses through a further expansion of repo operations to whatever scale required rather than outright purchases and an expansion of the overall balance sheet. It feels like it would be too rushed for the FOMC to jump straight into an expansion of the balance sheet today without a longer lead time to fully work out the fine tuning details and to prepare and explain that is a technical adjustment and not an additional statement of further easing in monetary conditions.
Market Validation
(Bloomberg 9/19/19)
Swap Spreads Crater to Record Low; Basis Squeeze Effect Resumes

Dollar swap spreads resume post-FOMC slide
with 2-year tenor dropping to record low dating back to late
1980’s. The post-FOMC tightening move has accelerated over
Thursday’s U.S. afternoon session across the curve in a sign of
market disappointment after expectations had built up for the
Fed to introduce a more permanent solution to the recent repo
squeeze.

The severe liquidity squeeze in the Overnight General Collateral Repo markets in recent days is certainly going to have dominated yesterday’s briefing on market conditions by the New York Open Market Desk and we suspect Federal Reserve Chairman Jerome Powell will be prepared to address the issue in his post-meeting presser later this afternoon.

We would offer four, by definition mostly conjectural, points:

** First, the easiest quick fix to the ending stress would be a third downward tweak to the spread of the Interest on Excess Reserves rate over the bottom end of Fed Funds range by at least 5 basis points. So we assume it is almost certain the formal policy statement from the Federal Open Market committee will include an implementation note that the IOER will be cut by a larger 30 basis points, putting the rate at 1.80%, relative to the highly likely 25 basis point cut in the target range for federal funds to 1.75%-2%.

It would be a bit more daring — and might stave off the potential need for another tweak before the end of the year to lower the IOER by even more, by 10bp to 1.75%, but it feels unlikely, though we do not have any particularly strong conviction on the size of a likely IOER tweak.

** Second, it would invariably only be a temporary reprieve at best, so we suspect the FOMC will have had to set aside time for a further discussion yesterday or today on longer term solutions to relieve the stresses and spikes in the repo markets to ensure the Open Market Desk’s control of short term rates. More broadly, that means the FOMC will need to accelerate its decisions on the next stage of balance sheet policy.

On that front, there has been plenty of market commentary the FOMC may opt today to announce an expansion of the balance sheet. It would mean more reserves in the funding markets and would in a sense simply be bringing forward what they always intended to do anyway with the economy “growing into the balance sheet” rather than further running off maturing assets.

** But third, we are hesitant to fully buy into the argument of the expanded balance sheet being announced today. We do not hold any strong conviction one way or another on this front, but we would wonder whether the FOMC will be more inclined to address the short term funding stresses through a further expansion of repo operations to whatever scale required rather than outright purchases and an expansion of the overall balance sheet. It feels like it would be too rushed for the FOMC to jump straight into an expansion of the balance sheet today without a longer lead time to fully work out the fine tuning details and to prepare and explain that is a technical adjustment and not an additional statement of further easing in monetary conditions.

** But as a fourth point, at minimum, Chairman Powell will ideally affirm in his opening remarks to the presser that the broader review of the short term markets and the broader balance sheet strategy — whether or when, for instance, a standing repo facility or a Term Auction Facility looking tool might be introduced, as well as perhaps the likely time frame to a balance sheet expansion — will be accelerated with an announcement made perhaps by the FOMC meeting at the end of October.

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