Four rate hikes in 2016? Markets say "nonsense" even after the strong payrolls report

On Friday the US Department of Labor report on US payrolls was significantly stronger than expected. Given such excellent economic news one would think the FOMC is going to continue on its path of steadily raising rates.

Source: Investing.com

Fixed income markets however don't believe that to be the case. The chart below shows the January 2017 Fed Funds futures contract over the past 3 days. The higher the value the lower the implied Fed Funds rate. The contract initially sold off sharply upon the announcement of the jobs figures but rallied shortly after. It ended up higher than it was prior to the report, indicating that the market expects the Fed to actually be less, not more aggressive in raising rates - even in the face of this strong employment report.

Source: barchart.com

The FOMC dot plot in December indicated that the Fed will hike rates four times in 2016. Surely with such an unexpected improvement in jobs, the Fed has to follow up on its "promises".

Source: FRB

Nonetheless, markets are completely discounting this projection, assigning only a 6.5% probability to a 4 or higher number of hikes in 2016. The chart below shows the futures-implied probability of rate hikes in 2016, with the horizontal axis representing the number of rate increases. This 4-or-higher probability is in fact materially lower than it was a couple of days prior to the payrolls report.

Source: CME

We saw a similar reaction in the treasury market, with the 2-year note futures reversing the sharp selloff which occurred when the report came out - and finishing higher than it started. So much for the treasuries selloff many have been expecting.

In the next post we will explore why the markets are discounting the latest US jobs reports in projecting the near-term Fed Funds rate path.

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Watch the Fed's RRP facility uptake jump at year-end

The Fed's policy announcement to raise rates had one technical detail that didn't get much media attention but is actually quite important. The reverse repo (RRP) rate was not only raised from 5bp to 25bp but the Fed also removed the cap on the RRP facility (which was at $300bn). It means that the program participants such as banks and money market funds can place nearly unlimited amounts of liquidity with the Fed overnight and earn 25bp. For now the Fed made $2 trillion of treasuries available for the RRP operations.

This sets the overnight riskless rate at 25bp which becomes the floor for the Fed Funds rate (and other money market rates such as commercial paper and private repo).

The immediate demand to place overnight funds with the RRP facility has been relatively modest at $143bn (note that we should see the reserves at the Fed drained by the uptake amount in the next H.3 report).

Source: NY Fed

Instead of using RRP, many market participants are enjoying the tightness in the private repo markets as general collateral (GC) repo now clears about 20bp above the RRP rate. The key reason for this relatively elevated spread is the increased regulatory pressure on banks to cut back on their balance sheet usage.

Source: DTCC

However the RRP demand is expected to spike at year-end as banks focus on window dressing. Given the somewhat elevated level of market stress and no cap on the RRP facility size, the uptake will be particularly large this time as we saw at the end of Q3 (note that the chart below shows the total reverse repo held by the Fed, which includes RRP).

Source: St. Louis Fed

Some are concerned that given the pressure on banks' balance sheets, this shift to RRP could disrupt the private markets on December 31st and send the GC repo rates to new highs.







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The Fed will hike the Fed Funds target range by 25bp but the rate will rise by only 20bp

Given the upcoming FOMC meeting, it's worth revisiting some of the mechanics around the rate hike. The FOMC is fully expected to lift the Fed Funds target range by 25bp - from 0-25bp to 25-50bp.

The current Fed Funds rate is around 13bp. Does it mean that after the FOMC meeting we will see the rate at 38bp, exactly 25bp above the current level? A number of analysts don't think so. Here is why.

In theory banks lend to each other overnight at a rate that on average should equal to the Fed Funds rate. However interbank lending has declined sharply after the financial crisis as banks rely on other sources of financing.

Source: St Louis Fed

A great deal of the overnight activity these days comes from the Federal Home Loan Banks (FHLBs) who often place their excess liquidity with commercial banks. They do this because they don't receive interest on reserves as private commercial banks do. Instead they place excess funds with commercial banks in order to receive some non-zero rate. That interbank rate however has to be some amount above the riskless overnight rate in order to make these transactions worthwhile for the FHLBs. That riskless rate in this case is based on the Fed's RRP (see post), with the latest auction setting at 5bp.

Source: NY Fed

The current spread between Fed Funds and the RRP is about 8pb and some view this spread as remaining relatively constant immediately after the hike. The FHLBs' demand to place liquidity will keep the Fed Funds rate at the lower portion of its range but at this minimal spread (8bp) above the RRP rate.

This week the Fed will be taking the following action.

Source: Morgan Stanley

With the RRP rate going up to 25bp and the spread to Fed Funds remaining constant, the new Fed Funds rate would move to 33bp. And that is 20bp (not 25bp) above the current level.

As a result of this projection, the calculation for the rate hike probability implied by the Fed Funds futures would need to change. Instead of being around 79% (chart below), which is based on the 25bp assumption, this week's rate hike probability is closer to 98% (based on the 20bp increase). The December 16th liftoff is now fully priced into the markets.

Source: CME

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The Fed on hold for a year according to the futures market

Futures markets have shifted expectations for the Fed's liftoff further out in time. The July-15 Fed Funds futures contract is only pricing a 12bp Fed Funds rate increase from the current levels - not enough for a full hike.

Source: barchart

In fact the mean expectation for the rate increase timing priced into the Fed Funds futures market is roughly a year from now.

Source: CME

This should slow the appreciation of the US dollar, as the Fed tries to avoid getting too far ahead of other developed economies in its normalization strategy.


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The Fed to pay foreign banks to keep the Fed Funds market alive

The FOMC continues to insist that the Fed Funds Target rate rather than the reverse repo program (see discussion) will play a central role in the upcoming rate normalization. Let's revisit the concept of the Fed Funds arbitrage (discussed in item 4 here) to show why that's a problem.

The Fed Funds rate (currently at about 9bp) is determined by the overnight interbank lending market in which banks provide liquidity to each other.

The market has shrunk dramatically since the financial crisis (see post), with the activity now limited to a few players with specific needs. US federal home-loan banks (FHLBanks) who, unlike commercial banks, do not receive interest on excess reserves at the Fed are the largest participants. In order to earn any interest at all on their excess liquidity they lend it to a handful of banks that use the funds for arbitrage. In particular foreign banks operating in the US have been active in this game, which nets them around 16bp in riskless profits.

It's easier for foreign banks to engage in this activity because many do not take in US deposits and therefore are not subject to FDIC fees. Because Fed Funds arbitrage involves increasing the balance sheet (and leverage) of the borrowing bank, US depositary institutions engaging in this are subject to higher FDIC fees. Foreign institutions on the other hand may not be as concerned about this.

Bloomberg: - The situation is complicated further by the reluctance of domestic banks to engage in arbitrage in the fed funds market, because Federal Deposit Insurance Corporation insurance fees increase proportionally with bank leverage, reducing the profitability of the trades.

“The only people that are really arbitraging at the moment would be the foreign banks without domestic deposits that need to get insured,” said David Keeble, head of fixed income strategy at Credit Agricole in New York. “Ultimately, you're allowing the arbitrage to continue and giving money” to foreign banks rather than domestic ones, he said.

Let's put this another way. The Fed is paying foreign institutions to participate in this market and bank federal home-loan banks' overnight liquidity.

Moreover, as regulation of foreign banking institutions in the US tightens, even these banks may decide to walk away from this strategy. The Fed may have to juice up the spread between the Fed Funds rate and the interest it pays on excess reserves (IOER) in order to keep these banks participating (the current 16bp of riskless profits may not be enough). Note that this "encouragement" comes at taxpayers' expense because it raises the Fed's effective funding rate, reducing the amount the Fed remits to the US Treasury.

Bloomberg: - To help keep that market alive, the Fed will have to pay those banks a premium to continue trading in it, which will eat into the profits the central bank remits to the U.S. government each year. And even then, foreign banks may be unwilling to continue their trades as stricter regulations on leverage take effect.

The whole policy of targeting the Fed Funds rate now depends on a handful of foreign banks' willingness to participate in this game - just as we approach the first rate hike in years. Is this really the Fed's best monetary policy tool going forward?

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Betting against the FOMC could end badly

In spite of the dovish tone from Janet Yellen at the press conference last week, the short term rates markets are betting that the Fed will become even more dovish in the months to come. Fed funds rates trajectory implied by the futures markets is significantly below the median projection by the FOMC.

Source: Barclays Research

Fed funds and eurodollar futures traders are playing the carry game - going long futures a couple of years out and riding them down the curve. The strategy had worked in the past. But is the Fed really going to turn more dovish? Barclays researchers believe that just the opposite will occur and the trajectory of rate hikes will steepen.

Barclays: - The “dots” also showed a faster pace for the hiking cycle. Notably, this occurred despite the fact that the revisions to the Fed’s inflation and UR [unemployment rate] projections were not very aggressive. We believe revisions are likely to continue in the same direction, i.e., lower UR and higher inflation; in turn, the path for the funds rate implied by the “dots” should continue to steepen.

The spread between the market and the FOMC is now close to extreme levels. The Fed's projected rate "dots" have been rising, while the futures traders continue to ignore it.

Source: Barclays Research

At some point however this is going to come to a head.

Barclays: - ... on balance, the Fed’s embedded economic projections are not too aggressive. While Fed Chair Yellen’s dovish stance may be playing a role in keeping rate hike expectations muted for now, if inflation surprises to the upside, Fedspeak can take a far less dovish tone (note the abrupt change by the BoE).

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The diminishing usefulness of the Fed Funds rate

As the massive over-liquidity in the US banking system reaches new highs, the amount that banks borrow from each other continues to decline. In the past some banks borrowed from other banks in order to meet their reserve requirements, but these days excess reserves are so large, the need for interbank financing has dramatically diminished.

Barclays Research: - The overnight market for unsecured bank loans has shrunk considerably since the Fed’s asset purchases expanded the level of bank reserves to nearly $3trn. With no short base left in the market and massive over-liquidity, banks no longer to need to borrow from each other or the GSEs to meet their reserve requirements. Indeed, overall bank reserves are now 34x bigger than required reserves.

This presents a problem for the Fed. The central bank's main policy tool for setting short-term rates involves targeting the Fed Funds Rate - effectively the average rate at which banks lend to each other overnight. With such lending having declined so dramatically (chart below), the Fed needs other tools to impact short-term rates on a broader scale. Otherwise the central bank would be attempting to influence rates by targeting a relatively narrow set of transactions among a few banks.

There are two other tools the Fed can potentially use as it prepares to exit the zero-rate policy. One is the interest it pays on excess bank reserves, which is currently at 25bp. If that rate increases, banks would be expected to increase the rates at which they lend out short term funds. That's because banks would always charge more on loans to the private sector than on "lending" to the Fed. And higher rates to the private sector would be the goal of this policy.

The other tool is the Fed's experimental reverse repo facility (fixed rate full allotment reverse repo facility or FRFA) - see post. The advantage of this program is that it broadens the set of counterparties beyond the banking system (see full list here), making a rate increase more effective. In particular FRFA gives money market funds a good alternative to treasury bills (3-month treasury bill now yields 3 basis points). If money market funds can increase yields by lending to the Fed (via FRFA), depositors will be able to earn more on cash. And that in turn will force banks to increase rates on deposits to keep customers from switching from savings accounts into something like the Vanguard Federal Money Market Fund. This program also allows the Fed to drain some of the bloated excess reserves by taking cash out of the system overnight.

With treasury bills near zero, it's not surprising that demand for the reverse repo facility is quite high even at the testing stage.

WSJ: - In her testimony, Ms. Yellen said when the Fed begins tightening credit, it will use a “number of complementary tools” that will collectively “push up the general level of interest rates.” She listed the reverse repos as one of tools that will “likely” be in the mix.

That’s a fairly strong endorsement for the still-experimental reverse repos.

Even in tests, the facility is popular: Operations over recent days have seen the Fed draining around $200 billion a day as participating firms navigate a shortage of short-term Treasury issuance related to the April 15 tax filing deadline and the government’s improving financial position.

Fed's testing of the reverse repo facility is generating considerable demand
(source: Board of Governors of the Federal Reserve System)

Both of these tools, the interest paid on bank reserves and the reverse repo facility, are currently on the table as the Fed debates their potential uses. When the central bank finally hikes interest rates, it won't be just about the Fed Funds Target Rate.

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From our sponsor:

The Fed preparing markets for the reverse repo facility (FRFA)

The Fed's "full-allotment overnight reverse repurchase agreement facility" (FRFA) - a mechanism to control short-term rates (see post) - is no longer just an academic exercise. Given how dysfunctional the interbank market has become (see post), using the fed funds target as the only post-QE monetary tool is no longer an option. FRFA allows the Fed to set a floor under the overnight secured lending rate (repo) by offering to borrow funds from a broad array of market participants - not just banks - at a fixed rate. Because this facility is effectively a riskless deposit with the Fed (legally it's a loan to the Fed), there shouldn't be any meaningful private transactions at rates below the FRFA rate - thus the rate floor. This mechanism also prevents the overnight rates from becoming negative - as was the case in some markets in Europe - to make sure that money market funds continue to function.

The Fed has been testing the facility since last September and seems to be happy with the results. The demand for the facility picks up sharply when the FRFA rate is about 4-5 bp below the private market repo rate. That's the discount that investors are willing to accept on their "deposit" rate in order to keep their money with the Fed rather than with a private institution.

Source: NY Fed (GCF stands for General Collateral Financing,
meaning that any treasuries can be used as collateral as opposed to specific securities)

Late last year the Fed raised the maximum FRFA bidding amount to $3bn from $1bn, as testing progresses to the next phase. When the program becomes fully operational, these amounts would increase dramatically.

One by one the Federal Reserve officials are preparing the markets for the FRFA implementation. Once QE winds down, the FRFA fixed rate becomes the next monetary policy tool.

1. Simon Potter (last month):

WSJ: - ... Simon Potter, who runs the New York Fed's markets group, gave a big thumbs up the reverse repo program based on what he's seen with the testing.

He said in his speech the overnight reverse repos "may strengthen the floor for short-term interest rates and, with it, the Federal Reserve's control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank's payment of interest to a wider universe of relevant counterparties."

2. Bernanke:

CBS: - Looking into the years ahead, Bernanke said the central bank has the tools -- including adjusting the rate on excess bank reserves and so-called reverse repurchase agreements, or repos -- to return to a normal policy stance without resorting to asset sales.

"It is possible, however, that some specific aspects of the Federal Reserve's operating framework will change,” he said. On the economy, Bernanke noted unemployment remains elevated at 7 percent, and said the number of long-term unemployed Americans “remains unusually high.”

3. Dudley:

BW: - Dudley said the Fed may decide to extend a program involving so-called reverse repurchase transactions aimed at giving it greater control over short-term borrowing costs.

The new tool, called the fixed-rate, full-allotment overnight reverse repurchase facility, is intended to put a floor under short-term money-market rates. It allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate in exchange for borrowing Treasuries in reverse repo transactions.

4. Williams:

BW: - Federal Reserve Bank of San Francisco President John Williams said reverse repurchase transactions may be an effective way for the Fed to control interest rates when it starts withdrawing unprecedented stimulus.

“This is potentially a very useful tool,” Williams said to reporters today after a speech in Phoenix. “It allows us to manage short-term interest rates more directly even at the same time that we have a very large balance sheet and lots of excess reserves.”

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From our sponsor:

If QE is "heroin", what is "methadone" and how do we avoid "side effects"?

The Federal Reserve remains concerned about exiting the massive bond buying program that has been in place for over a year now. The program has become a bit of a trap (see post), creating a dependence on unsustainable levels of stimulus. The concern is that in an environment where inflation is at historically low levels, cutting back on monetary stimulus could put significant downward pressure on prices, creating deflationary pressures and forcing the Fed to resume or even increase the program (similar to Japan). Using the addiction analogy (see this video for example), this is the equivalent of a relapse risk for those suffering from substance abuse. It turns QE from an extraordinary crisis fighting mechanism meant to be used only under extreme situations into an ongoing monetary policy tool. The Fed desperately wants to return to the days of simply adjusting short-term rates to drive policy.

So how does one minimize the impact of taper to reduce the probability of returning to "unconventional" programs? One approach is something that opiate addiction clinicians have been using for some 30 years. An effective treatment for heroin addiction is the use another, less dangerous opiate called methadone. It reduces withdrawal symptoms without creating intoxicating or sedating results, helping many addicts quit. So if heroin is analogous to the Fed's QE program for the economy, what is the equivalent of methadone?

Many are arguing that lowering the Interest on Excess Reserves rate (IOER) could potentially counteract some of the QE withdrawal symptoms. IOER is currently at 25 basis points, and while that was considered to be extraordinarily low back in 2008 when it was introduced, in the days of record low short-term rates many view it as being too high. That's because banks are quite comfortable paying near-zero on deposits (including deposits from the Federal Home Loan Banks) and receiving 25bp on reserves - a riskless way to generate revenue (see post). That spread according to some is holding back credit expansion in the US. The chart below shows growth in non-cash assets of all banks operating in the US - an unsettling trend for many economists.

By making it less profitable to hold on to cash, some argue that lowering the rate on reserves should "dislodge" the barrier to a more vibrant credit expansion.

Reuters: - The [IOER] rate has been criticized, however, for encouraging banks to park cash idly with the central bank instead of using funds to lend to companies and consumers that many say is needed to stimulate the economy and reduce unemployment.

Yellen, who has been nominated to succeed Fed chair Ben Bernanke at the end of January, said on Thursday that cutting excess reserves is "something that the FOMC has discussed, and the board has considered, on past occasions, and it is something we could consider going forward."

When cutting this rate simultaneously with the first series of cuts in securities purchases, the Fed could attempt to blunt the "withdrawal symptoms". This may avoid the "cold turkey" taper, which many view as dangerous given the disinflationary trends in the United States (see Twitter chart) and elsewhere in the developed world. So why hasn't the Fed already taken this step? As with any medication, this form of "methadone treatment" may have some side effects.

Europe found out the hard way that setting the rate on reserves to zero can severely damage the money markets industry - which is basically what happened in the euro area after Mario Draghi's rate announcement in July of 2012 (see post). While we've received emails arguing that money market funds are irrelevant, one has to keep in mind that in the US and offshore the industry holds $2.7 trillion of dollar deposits. Nobody wants havoc in that sector, particularly as taper takes hold.

That's why the Fed has been working on a way to avoid this potentially dangerous complication. It is called the Overnight Reverse Repo Facility (discussed here). This tool gives the Fed some control over the short-term rates outside the banking system to make sure money market rates do not dive below zero. Money market funds would be allowed to effectively deposit cash directly at the Fed (technically they would be lending to the Fed) and earn rates that are above zero. The program would set a floor on the overnight rates and in the long run the facility could be used in conjunction with (or even instead of) the fed funds rate to drive monetary policy.

Reuters: - Market speculation that the Fed may be nearer to acting on a cut also increased on Thursday after influential firm Medley Global Advisors said in a report that the Fed may cut the excess reserve rate, noting that it has more flexibility to do so now that it has been testing its reverse repurchase agreement program.

In reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. This helps the Fed control short-term rates as the supply of collateral can stop market disruptions from rates falling to zero or into negative territory as cash floods into short-term markets.

The Fed has been testing this program since September.

"The logic for cutting the IOER now, would be to better align the IOER with other short-term rates and hopefully encourage greater market-based lending," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.

"With the creation of reserve draining facilities, like the Overnight Reverse Repo Facility, the Fed now has the ability to better align rates without destabilizing money markets given that the Fed can essentially put a 'floor' on short-term rates by injecting collateral/draining reserves into the market. This would have a stabilizing effect," he said.

We could therefore see the Fed execute all three policy changes at the same time:
1. Taper (weaning the economy and the markets off QE "heroin")
2. Reduction in the IOER rate to encourage lending (methadone treatment for reducing withdrawal symptoms)
3. Introduction of the Overnight Reverse Repo Facility to keep the overnight rates from dropping below zero and destabilizing money markets (managing medication side effects).

Of course it is not entirely clear if lowering the IOER rate will encourage significantly more lending. However such action will certainly send lenders to seek out other sources of revenue in order to replace the easy money generated by the current spread between IOER and deposit rates.

SoberLook.com

From our sponsor:

Market's overnight rate expectations are more dovish than the Fed's own forecasts

Market expectations of the first rate hike have once again been pushed out to May of 2015.

The combination of the Fed maintaining its unprecedented monetary easing program at the September meeting as well as the assumption that Janet Yellen will be taking over for Bernanke would suggest that the central bank is farther from any rate adjustment than was expected earlier this year. In fact the market now considers the Fed to be more dovish than the Fed's own rate forecasts would suggest.

Barclays Research: - Despite stronger than expected data, the market has pushed out hike expectations. ... the market is now pricing in the Fed to hike to 0.75% by the end of 2015 vs the Fed’s [own] forecast of 1% and 1.8% by the end of 2016 vs Fed’s forecast of 2%.

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From our sponsor:

Implied rate hike date moves to October of 2014

The Fed Funds futures curve steepened again on Friday, bringing forward the implied date of the first rate hike by the Fed.

Fed Funds futures curve shift as a result of Friday's employment report 

The date is now closer to October of 2014 as opposed to May of 2015 discussed about a month ago (see post) - an immense steepening in such a short time. That means the market now expects the current securities purchase program to end before the start of the fourth quarter of 2014.

SoberLook.com

From our sponsor:

The Fed to face challenges as it ultimately exits the unprecedented monetary expansion

The recently released minutes of the last FOMC meeting made some economists and market participants begin contemplating the Fed's exit, its timing, and the implications. This is because the FOMC's discussion sounded a bit more hawkish than many had anticipated.

FOMC Minutes: - ... many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.

But what will an exit from such extraordinary expansionary policy actually look like? Much of course will depend on the trajectory of the US economy in the next couple of years, but there are two key possibilities. One is that the Fed will simply end purchases and let the securities naturally pay down (due to prepayments on MBS) and mature. However, given the rate at which excess reserves are now being created through asset purchases, it may take too long to "drain" these balances (excess reserves represent the largest component of the monetary base now).

According to DB, without any securities sales it will take until 2020 before bank reserves return to normal - after the latest round of purchases as well as purchases yet to come. If inflationary pressures pick up, the pace of a "passive" exit may end up being insufficient.

The alternative would be to begin selling securities in order to accelerate the draining of the reserves. The chart below compares the two potential scenarios.

The liability side of Fed's balance sheet (source: Deutsche Bank)

But there is a cost to this "active" exit strategy. Long before the Fed officially telegraphs that it will begin selling, the markets will push long-term rates higher. MBS durations will extend as prepayments slow, and MBS spreads will likely widen. The market will begin effectively "front-running" the Fed. Moreover, MBS holders and mortgage servicers will begin to actively hedge their portfolios (something many are not doing now due to high prepayment activity) by shorting long-dated treasuries and steepening the yield curve more.

By the time the Fed actually begins selling, its massive securities holdings will likely be "under water" and many sales will result in realized losses (note that the Fed generally isn't concerned about unrealized losses that would be generated during a "passive" exit).

In recent years the net interest income generated by the Fed (less operating expenses) hit a record due to all the coupon payments in the Fed's portfolio. This income has been remitted to the US treasury on an annual basis. But as losses from sales accumulate, the "dividend" which the Fed has been paying in the past, will dwindle and possibly turn into a loss. The amount of loss will depend on interest rates as well as on the timing of the exit. According to DB, if sales begin this summer - an unlikely scenario - the net losses could largely be avoided.

Fed's net income under 3 scenarios (source: Deutsche Bank)

The blue line above dips further down of course if long-term rates move higher than projected. Some FOMC members are in fact becoming concerned about this outcome.

FOMC Minutes: - Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound...

Furthermore, if the Fed raises the overnight (Fed Funds) rate, it will also have to increase the rate it pays on excess reserves (the two will likely be adjusted in tandem), increasing the cost of liabilities and exacerbating losses. The "active" exit strategy therefore looks quite messy.

In practice however the Fed should be able to absorb such a loss. It would in effect "borrow" from itself to cover the loss until it generates enough income to extinguish this P&L item. This is "accounting magic" that only a central bank can implement.

DB: - Possibly in anticipation of [losses], the Fed adopted new accounting principles in January 2011, which specify that realizations of negative net income are capitalized as an asset on their balance sheet. This “asset” would be counterbalanced by the creation of additional reserves of value equal to the asset. That is, the Fed would in essence create new money to cover its losses. The increase in reserves created to deal with the Fed’s income losses will only partly offset the reduction in excess reserves associated with the asset sales that generated the losses in the first place.... Over time, the deferred asset would accumulate if the Fed continued to experience negative net income and be reduced when net income turned positive. Once the deferred asset was reduced to zero again, the Fed would resume remittance of its positive net income to the Treasury.

Other than the loss of revenue for the US Treasury, the problem for the Fed will be mostly reputational, as it carries these losses on its balance sheet - potentially for years. But given the public's perception of the Fed these days, such a loss is something the FOMC will likely take quite seriously.

SoberLook.com

From our sponsor:

Shifting expectations of the Fed's first rate hike

Discussions on the first tightening move by the Fed are taking place once again, as investors become a bit more optimistic about the US economy. The tightening action timing was brought into spotlight by the latest speech by Bernanke. The Chairman did not discuss further QE in 2013, which was somewhat unexpected (and disappointing to some).

WSJ: - Interest-rate futures nudged forward monetary tightening expectations Tuesday after remarks from the head of the Federal Reserve didn't offer hints of more Treasurys buying next year.

With a current Treasury buying and selling program due to end this year, bond investors have increasingly expected the Fed to announce it will continue the purchasing-end of those efforts in 2013. Though he maintained that the labor market is still far from healthy, Fed Chairman Ben Bernanke didn't tip his hand on future stimulus measures in a speech Tuesday, causing some disappointment.

The thinly traded July 2015 Fed Funds futures contract reflected a 50% chance for a 0.25 percentage point policy-rate increase at the mid-2015 Fed meeting. That's up from 44% late Monday. As the Fed has stated, it doesn't intend to lift its policy rate from near-zero through at least mid-2015.

Odds for an early-2015 rate move rose to 12% from 8%.

The October survey of primary dealers was showing 41% of Wall Street economists expecting action by mid 2015.  Rate futures are now pointing to a 50% probability.

Question for primary dealers: "Of the possible outcomes below, please indicate the percent chance you attach to the timing of the first federal funds target rate increase." (source NY Fed)

In fact the Fed Funds futures two years out (October 2015) are implying 50bp for the overnight rate.

Fed funds futures implied overnight rate (source: CME)

It is not surprising that market participants are beginning to talk about the end of zero rate policy from the Fed. The spike in housing construction has been quite sharp (see earlier forecasts) and some are beginning to think this could lead to a more robust growth going forward.

SoberLook.com

From our sponsor:

Those believing the Fed is on hold for the next 3 years will be in for a rude awakening

Misconceptions still persist that the Fed is on hold with respect to rates until at least late 2014.

WSJ (Feb 16th): ... They said after their last meeting in January they expect to keep rates at "exceptionally" low levels until late 2014.

The markets would disagree. The Fed Funds futures have the first rate hike (25bp) centered around August of next year and the second hike (to 50bp) on July of 2014.

Fed Funds Futures (implied rate) expected rate hike dates

The market has completely reversed the Fed's announcement on January 25th. In fact the expectations for the first hike are now even earlier than they were before the Fed's statement.

Fed Funds Futures  (implied rate) expectations of rate hike shifted to an earlier date than was priced in before the Fed's announcement

The market is fully ignoring the FOMC's prolonged zero rate forecast. If Bernanke tried to lower short-term rate expectations by the announcement, he failed miserably (though it's possible that was not his intent), as the rate expectations are now even higher than prior to the announcement. Why is the market pricing in higher short-term rates (an early rate hike)? The answer has to do with relatively strong economic data coming out of the US and rising commodity prices. All of this is driving up inflation expectations. The chart below shows TIPS implied 2-year forward inflation expectation now comfortably above 2%, the Fed's inflation target.

TIPS implied 2-year forward (breakeven) inflation expectation

The market is prepared for the first rate hike in about 16 months, possibly sooner. Those who are becoming complacent believing the Fed is on hold for the next 3 years will be in for a rude awakening.

SoberLook.com

A Discount Rate cut? It just doesn’t matter

The rate on the Fed Liquidity Swap has been changed today to the OIS rate + 50 down from (OIS +100).

The Fed: The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

The liquidity swap represents the Fed providing dollar funds to the ECB and other central banks while taking euros or other currency as collateral. The all-in rate should be around 60 bp. If the US chartered banks want to borrow from the Fed, they have to pay 75 bp – the so-called Discount Rate. Some have speculated that it makes no sense for the Fed to offer lower rates to foreigners than it would to the US banks and therefore the Fed intends to lower the Discount Rate.

MarketWatch: “It is now cheaper for foreign banks to borrow dollars from their local banks than it is for U.S. banks to borrow dollars from the Fed, so we could see a 25 basis point cut in the discount window in the coming days to level the playing field,” said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets.

First of all that is unlikely because the Fed clearly stated at the last meeting that they want to raise not lower the discount rate:

FOMC Oct 3d Minutes: As another step toward restoring a pre-crisis discount rate structure, some directors supported increasing the primary credit rate by 25 basis points (to 1 percent) at this time. Such an action would result in a 75-basis-point spread between the primary credit rate and the upper end of the Federal Open Market Committee's target range for the federal funds rate. These directors favored a move toward normalization of the primary credit rate in light of current and anticipated economic conditions.

Second of all US banks are NOT borrowing from the Fed these days – they have no reason to. In fact they are lending via excess reserves.  The rate that is important is the “Fed Funds Effective Rate”, the rate at which banks lend dollars to each other overnight. And that’s sitting around 8-9 basis points.

 Fed Funds Effective (FEDL01 Bloomberg)

The need for dollars directly from the Fed comes from the European banks (via the ECB) because US banks and US money markets are limiting their lending to them. Thus lowering the Discount Rate simply won’t make any difference.

SoberLook.com

As LIBOR declines, banks hoard more cash at the Fed

US Banks continue to hoard over $850 billion in cash at the Federal Reserve. They are required to hold some reserves there, but since the Fed started paying interest on deposits last year, that amount spiked and stayed at these elevated levels.




In fact that deposit amount has been rising recently. The reason has to do with the collapse in interbank deposit rates (LIBOR). The chart below shows just how flat the LIBOR curve has become:




Out to 3 months the rate is almost the same as the overnight rate. It's an indication of the spectacular rise in confidence banks have in each other and their own ability to fund themselves short-term. If you are a bank treasurer however, and you have a choice of depositing your excess cash with other banks or with the Fed at almost the same rate, your preference would be to park the money with the Fed. And that is exactly what is taking place with the decline in LIBOR rates.

Part of the problem with Western banks these days is that much of the liquidity is trapped within the banking system. One way some central banks have been dealing with this is to lower the deposit rate on reserves to zero, and even below zero. This forces banks to look for a better place to put the money and possibly do some lending. But it continues to be a challenge to encourage banks to lend outside the banking system; they either lend to each other or to the central bank (via reserve deposits).

So far in the US there is no evidence that much of this cash is making it's way to the consumer. Consumer loans outstanding at commercial banks have actually been declining.


source: the Fed


That is why the expectation is for the Fed to stay put for a while with respect to rates. Until some of the liquidity the banks are hoarding in reserve deposits is unlocked, consumer credit will continue to stay constrained.

The market's expectation of a rate hike keeps getting delayed

The Fed is now officially expressing optimism about the economic turnround that is supposedly taking place.

WSJ: Federal Reserve Chairman Ben Bernanke said Tuesday that the recession was "very likely over," as consumers showed some of the first tangible signs of spending again.

Mr. Bernanke, who had become cautiously more upbeat in recent weeks amid signs of third-quarter growth, said for the first time that forecasters agree "at this point that we are in a recovery."

If the Fed is really confident we've turned the corner, they should be getting ready to raise rates. Fed Funds were at 18 basis points today - that is banks are lending to each other at 0.18% annualized. It's basically interest free money. So if what Mr. Bernanke said this week is true, the Fed is preparing to be (or at least thinking about) raising rates.

But the market doesn't believe the Fed is going to raise rates any time soon. The Fed Funds futures, the market's bet on where overnight rates will be in the future, are forecasting a rate increase that's increasingly further away. The following chart shows the futures curve changes from June-09.




In June the market was expecting that by Feb-2010, the overnight rate will be near 75 bp - indicating a couple of increases by early next year. But now the first increase is not priced in until May - June, and it will be July - August before we reach 75 bp. The market is expecting the Fed to keep a near zero rate policy for another 8-9 months. That is obviously contributing to market strength, particularly in fixed income, but keeping rates at zero in a growing economy is a dangerous game. There are two possible outcomes here. Either the Fed doesn't really believe the recovery they announced is real and will keep rates near zero for a long time, or the markets are in for a big rate hike surprise.

Money markets have reached a level of stability not seen since 07

As banks reach for more yield, they are starting to lend to each other longer term. In fact banks are trying to lock in term rates that are still significantly higher than the overnight rate. We’ve come a long way from interbank lending being limited to overnight only. In the Fall of 08, term LIBOR was merely a quote – nobody was actually lending term.

As the Fed floods the system with cash, the Fed Funds effective rate has dipped below 16 bp.

Fed Funds Effective rate


Banks are placing term funds and borrowing overnight, which is a fairly profitable trade with low risk. Usually the risk with these trades is that the Fed suddenly raises rates, making overnight financing more expensive than term. There is little likelihood of such an event these days, and with the overnight rate staying under 25 bp, the 1-3 months term trade will generate 25-35 bp. The Fed wants it that way to improve interbank lending, reduce reliance on TAF, and boost bank profitability.

This willingness to lend longer term has brought 3-month LIBOR below 50 bp, which is a record low. The one and three months LIBOR rates have converged, flattening the short-term yield curve.

1-month and 3-months LIBOR


The 3 months LIBOR-OIS (overnight index swap) spread has dropped below summer 2007 levels. This spread compares actual LIBOR to the level LIBOR would be based on projected overnight rate. The higher the spread, the higher the perceived credit/financing risk. Money markets have reached a level of stability not seen for some time, which is critical in order to keep the credit markets open.

(3-month LIBOR) - (3 months OIS)