US monetary policy normalisation tool box stocked and ready for second rate hike Mikael Olai Milhøj Senior Analyst, International Macro Research +45 45 12 76 07 milh@danskebank.com Jens Nærvig Pedersen Senior Analyst, FX & Commodities Strategy +45 45 12 80 61 jenpe@danskebank.dkk Mathias Røn Mogensen Analyst, Fixed Income Research +45 45 13 71 79 mmog@danskebank.dk 12 December 2016 Investment Research www.danskebank.com/ci Important disclosures and certifications are contained from page 12 of this report
Summary In this presentation, we analyse the Fed s operational framework, the current and future conditions in the Fed funds market and the settlement of the Fed funds rate. At the FOMC meeting this week, we expect the Fed to raise the Fed funds target range by 25bp to 0.50-0.75%, from the current 0.25-0.50%, by setting the IOER at the top of the range (0.75%) accompanied by the ON RRP rate 25bp lower at the bottom of the range (0.50%). For more details, see FOMC Preview: Fed set to hike focus on outlook for 2017, 9 December. In our view, the ON RRP facility is likely to remain unchanged for now (except the offering rate) with no cap on the overall size but caps on individual usage, i.e. an overall size of the ON RRP facility limited only by the value of Treasury securities held outright in the SOMA (currently USD2,405bn) with each counterpart having a limit of USD30bn per day. We do not expect the Fed to change its reinvestment policy in 2017. We expect the effective Fed funds rate to remain in the middle of the target range. However, there is a risk the effective Fed funds rate could fall below the ON RRP rate over the turn of the year. The higher effective Fed funds rate in H2 16 appears to reflect more cautious liquidity management in the wake of the UK referendum and shifting investments by money market funds in advance of the money market reform applicable since October 2016. 1
The Fed still needs to steer the Fed funds rate with a bloated balance sheet Total USD reserves in the Fed funds system are more than USD2,000bn, i.e. well above the reserve requirement. Still very large excess reserves Fed reserve balance and reserve requirement (USDbn) Depository institutions have reserve accounts with the Fed earning the interest rate on excess reserves (IOER), currently 0.50%. The large excess reserves are a result of the large bond holdings on the Fed s balance sheet (asset side), which are financed by large bank reserves (liability side), and the IEOR, which gives an incentive to deposit at the Fed rather than lending out to the economy. Not all participants in the Fed funds market have this possibility in particular, the governmentsponsored enterprises (GSEs) (Fannie Mae, Freddie Mac and the Federal Home Loan Banks [FHLBs]) and the money market funds, which need to lend to the Fed funds market. Source: Federal Reserve 2
The Fed s operational framework Theoretically a two-tier floor system but a de facto corridor system Fed monetary policy rates (bp) IOER FF spread drivers * Balance sheet cost * FDIC cost (deposit insurance cost) * Liquidity at banks vs at GSEs/Money Market Funds The Fed s pre-crisis operating model Create a small shortfall in the level of bank reserves. Need for O/N transactions. Push banks to bid up cash in the Fed funds market to cover the shortfall control liquidity injection with OMO. I.e. keep Fed funds rate within the policy target. Worked when bank reserves were under USD50bn. Banks were not getting paid on their balances at the Fed. New tools to control short-term money market rates Source: NY Fed, Bloomberg IOER: The rate that the Fed pays to banks for reserves held at the central bank. ON RRP: Similar to IOER, except the cash is lent to the Fed against Treasury collateral from the SOMA portfolio. In addition to banks, eligible counterparties include large money market funds and most of the GSEs. In theory, the ON RRP rate should be the lowest rate in the economy (riskless loan to the Fed collateralised with Treasuries). While the IOER and ON RRP are both floor rates, the Fed has created a de facto corridor system, as the effective Fed funds rate stays within the range between the two rates. 3
Settlement of the effective Fed funds rate with this new framework In the absence of market friction, depository institutions would arbitrage out the spread between the Fed funds rate and the IOER. Visible turn effects and a generally higher effective Fed funds rate in H2 16 Fed monetary policy rates (bp) Regulatory issues reduce the incentive of depository institutions to increase their balance sheets, as costs rise with the size of the balance sheet, in particular over turns. This implies that the Fed funds rate has a margin to the IOER. In order to have a handle on this margin, the Fed uses the ON RRP facility to drain reserves. The higher effective Fed funds rate in H2 16 appears to reflect more cautious liquidity management in the wake of the UK referendum and shifting investments by money market funds in advance of the money market reform applicable since October 2016. The FOMC s minutes from the July 2016 meeting state the following. The modestly higher average effective Fed funds rate than in the previous intermeeting period appeared to reflect at least in part more cautious liquidity management by some money market participants in the wake of the UK referendum. The rising take-up of the system's ON RRP facility seemed to be in part the result of shifts in investments by money market funds in advance of the scheduled implementation in October of changes to the regulation of the money market fund industry. Source: Federal Reserve, Danske Bank Markets 4
The Fed s key instrument - the ON RRP facility, the basics While IOER is available only to depository institutions, ON RRP can be made available to non-bank investors that are active in the money market. The list of eligible counterparties for the ON RRP facility is thus broader and includes money market funds, GSEs such as Fannie Mae, Freddie Mac and FHLB and primary dealers (see list). In general, any counterparty that is eligible to participate in the ON RRP facility should be unwilling to invest funds overnight with another counterparty at a rate below the ON RRP rate. Hence, in practice, the effective Fed funds rate will be below the IOER but above the ON RRP rate. The increasing outflow from prime money market funds into government money market funds ahead of the US money market reform applicable from October 2016, seems to have increased the take-up at the ON RRP facility. There is still room for further use of the ON RRP facility. The total use of RRP (both ON and term) has so far not been above USD640bn, which is well below the current USD2,405bn overall effective cap, i.e. the available amount of Treasuries to lend out. Allotted amount in the ON RRP facility in different segments Daily ON RRP allotment (USDbn) Note: Details after 30 June 2016 not disclosed Source: Federal Reserve, Bloomberg, Danske Bank Markets 5
The Fed s key instrument - the ON RRP facility Since December 2015, the overall size of the ON RRP facility has been limited only by the value of Treasury securities held outright in the SOMA and each counterparty has a limit of USD30bn per day. The number of eligible counterparties for the ON RRP facility and the limit of USD30bn per counterparty implies an overall ON RRP facility size cap of approximately USD4,000bn, Hence, the effective cap for the ON RRP facility is the value of the Treasury securities held outright in the SOMA, i.e. USD2,405bn, as of 7 December 2016. The offering rate is currently 0.25bp, i.e. the spread between the IOER and the ON RRP is 25bp. At the November 2016 meeting, Fed Chair Janet Yellen reiterated that additional experience with the Federal Reserve s current monetary policy implementation framework would help inform policymakers future deliberation of issues related to a long-run framework and that decisions regarding these issues would not be required for some time. Furthermore, according to Fed staff, the ON RRP facility remains an important element of the operating regime with abundant supply of reserve balances and it could also be effective with an appreciable smaller balance sheet and supply of reserves. Hence, the ON RRP facility is likely to remain unchanged for now (except the offering rate) with no cap on the overall size but caps on individual usage. However, financial stability arguments suggest limiting the ON RRP facility as the facility might exacerbate disruptive flight-to-quality flows during a period of financial stress. 6
We expect the effective Fed funds rate to stay in the middle of the target range risk of fall below ON RRP rate over turn of year We expect the effective Fed funds rate to stay in the middle of the target range. Hence, another 25bp rate hike would leave it around 0.625%. Fed funds effective to IOER and ON RRP at lift off Fed policy rates, current and lift-off expectations, bp The market is currently pricing the effective Fed funds rate to settle around 0.65% and at 0.50% over the turn of the year. In 2015 before the Fed hike, the marked priced the effective Fed funds rate to settle around 0.32% and at 0.27% over the turn of the year. Initially the effective Fed funds rate settled around 0.36-0.37% and at 0.20% over the turn of the year. We see a risk that the effective Fed funds rate may fall below the ON RRP rate over the turn of the year, as it did a year ago. The cap on the use of ON RRP has not changed since last year, when it was not sufficient to keep the Fed funds rate within the target range. Furthermore, new regulation comes into effect from 1 January, i.e. US banks are required to hold LCR of 100%. Source: Federal Reserve, Danske Bank Markets 7
Reducing the balance sheet - a longer term issue 500 Par Value (USD bn) 450 400 350 Fed s bond portfolio System Open Market Account (SOMA) 4.205bn 3% 0% 0% 41% 300 250 56% 200 150 100 50 0 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 Maturity Agencies FRN MBS Notes and Bonds TIPS Note: current face value used as par value for MBSs Source: Federal Reserve, Danske Bank Markets, 7 December 2016 data In the statement from the FOMC meeting in December 2015, we learnt that the FOMC anticipated that it would continue to reinvest until normalisation of the level of the Federal funds rate is well under way. In 2016, there has been no change to reinvestments and no further discussions regarding the reinvestment policy. We do not expect the Fed to change its reinvestment policy in 2017, because the Fed will, in our view, not be well under way with only two additional hikes and because it seems to us that the Fed is closer to accepting that large balance sheets may be a more permanent part of the Fed s operational framework. If the Fed ends reinvestments, it is likely to do so gradually. Letting the balance sheet run down without smoothing would mean a very choppy reduction. 8
Appendix 9
Impact of Basel III on the Fed funds market Liquidity coverage ratio (LCR): this generally discourages short-term borrowing (< 30 calendar days) in the money market. Implementation of LCR started in 2015 and it will be fully implemented in the US from 1 January 2017, when banks are required to have an LCR of 100%. LCR is measured on an ongoing daily basis, which means that it has a permanent impact on the market. It has a permanent negative impact on the demand for Fed funds and a permanent positive impact on demand for reverse repos and thus a permanent negative effect on the supply of reserve balances. Significant negative impact on US monetary base on quarterly basis Upper: USDtrn, lower: USDbn Leverage ratio: this generally gives a disincentive to buildup exposure. It is derived differently for different segments of banks and depends on on-balance sheet and off-balance sheet items. For some it is calculated on daily averages, for some on the basis of the average of the month-end balance sheet and for some on the quarter-end balance sheet. i.e. the market impact is to some extent temporary around month-end and quarter-end. Net stable funding ratio will be introduced in 2018. It will create a further disincentive to borrow in the short-term money market. Note: The Federal Reserve may conduct reverse repurchase agreements with foreign official and international accounts as a service to the holders of these accounts. The Fed Reverse Repos time series in the chart above contains both these reverse repo agreements and transactions with primary dealers and other counterparties who have been established specifically to transact in reverse repurchase agreements. Weekly frequency data (middle of period). Source: Federal Reserve, Danske Bank Markets 10
The US money market reform - shift in investments, key elements The US money market reform (MMR) was adopted in July 2014 and came into effect on 14 October 2016. The key elements of the US MMR are the rules for floating net asset value (NAV) and the liquidity fees and redemption gates, i.e. as follows. NAV: The MMR introduces a floating NAV for sales and redemptions based on the current market value of the securities in the portfolio, instead of a stable USD1 share price. Hence, the risk of breaking the buck (NAV going below USD1) has, all else being equal, increased. Liquidity fees and redemption gates: The MMR provides new tools to money market funds to address a potential run on a fund. The new tools will give funds the ability to impose liquidity fees or to suspend redemptions. They will be enacted if a fund s level of weekly liquid assets falls below a certain threshold. Importantly, government money market funds are allowed to continue using the amortised cost method and are not subject to the new fees and gates provisions. For more details, see The US Money Market Reform: The Scandi Angle, 9 August. The outflow from prime money market funds into government money market funds accelerated ahead of 14 October 2016 Assets under management (USDtrn) Source: Investment Company Institute Prime money market fund A money market fund that invests primarily in corporate debt securities. Government money market fund A money market fund that invests 99.5% (formerly 80%) or more of its total assets in cash, government securities and/or repurchase agreements that are collateralised solely by government securities or cash. Source: US Securities and Exchange Commission 11
Disclosures This research report has been prepared by Danske Research, a division of Danske Bank A/S ( Danske Bank ). The authors of this research report are Mikael Olai Milhøj, Senior Analyst, Jens Nærvig Pedersen, Senior Analyst and Mathias Røn Mogensen, Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in this research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. Danske Bank s research reports are prepared in accordance with the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. 12
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