The Federal Reserve is building the tools it will need to exit from its extraordinary monetary policy. Just as the market was against the Fed tapering, it will worry periodically about rate hikes, but we think the Fed is gradually laying the groundwork.
•The three-month Eurodollar futures market now expects a 1.2 percent Fed funds rate increase during 2016 after smaller increases in 2015, beginning the process of market acceptance of a gradual normalization.
The Fed’s liabilities have reached $4 trillion. It is expected to borrow $75 billion in January, investing the proceeds in Treasury bonds ($40 billion) and MBS ($35 billion).
•To date, almost all of the Fed’s incremental funding has come from excess reserves, up nearly $1 trillion in 2013 to $2.3 trillion. Paper currency rose $70 billion to $1.2 trillion. Through increases in excess reserves, the Fed buys bonds on credit from primary dealers. As discussed in previous pieces, excess reserves can be thought of as a Fed IOU. It pays a 0.25 percent interest rate which can be increased at the Fed’s discretion to maintain liabilities.
•Since September, the Fed has been testing a system to expand its borrowings through reverse repos as an alternative to excess reserves. One difference is excess reserves are used to borrow from primary dealers, a limited universe, whereas reverse repos can be used to borrow from a broad range of counterparties including Fannie Mae and Freddie Mac (see Fed Tools To Affect Short-Term Credit Markets on Dec. 16, 2013.) The Fed’s borrowings through reverse repos spiked at year-end, with the Fed borrowing $198 billion on December 31 at a 0.03 percent rate from 102 counterparties while reducing its borrowing through excess reserves.
•At the December meeting, the FOMC raised the per counterparty borrowing limit to $3 billion per day from $1 billion per day. We expect the Fed to extend the repo program at the January 29 FOMC meeting and think reverse repos will be a key part of the Fed’s medium-term implementation of monetary policy.
The Fed can be thought of as a structured investment vehicle (SIV), borrowing short and lending long. It does not create any money other than the very gradual growth in paper currency. Like a SIV, the Fed is a net buyer of duration, using heavy leverage (debt to capital ratio) exceeding 70 to 1. Unlike the commercial SIVs of the 2000s which sometimes borrowed in the repo market in order to buy CDOs, the Fed is safer because it has an assured, unlimited source of funding (primary dealers) and only invests in government guaranteed instruments. It bears interest rate risk, but not any meaningful credit risk.
•By buying duration like the SIVs in the 2000s, the Fed causes the private sector to lengthen the duration of its issuance – guiding credit into bonds rather than business loans. This helps established borrowers at the expense of newer borrowers, in our view slowing economic growth. In the 2000s, the SIVs caused growth in non-conventional or jumbo mortgages by buying private label MBS.
•In contrast with the 2000s when bank credit expansion was at best loosely regulated, private sector credit growth is being restrained by the regulatory process, leaving a contractionary or zero-sum credit environment rather than the stimulative (and more risky) credit expansion of the 2000s.
•As the repo program expands, the Fed will be able to increase its borrowing from Fannie and Freddie, some of which is invested in their MBS. It is a circular process, increasing the connection between the Fed’s balance sheet and those of Fannie and Freddie, all of which are exposed to interest rate risk.
Our view is that the Fed is establishing the tools it will need during the normalization process. It should be able to hold to maturity a portion of its $4 trillion in assets and fund it efficiently in floating-rate markets. The recent spike in the Fed’s use of reverse repos shows that the Fed is in position to diversify its liabilities from excess reserves into the reverse repo facility. Short-term funding puts interest rate risk on taxpayers, but as long as interest rate hikes move in parallel with economic growth, the budget consequences of rate hikes should be manageable.
David Malpass is the President of Encima Global and a contributor to e21.
