Download US monetary policy normalisation tool box stocked

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
[email protected]
Jens Nærvig Pedersen
Senior Analyst, FX & Commodities Strategy
+45 45 12 80 61
[email protected]
Mathias Røn Mogensen
Analyst, Fixed Income Research
+45 45 13 71 79
[email protected]
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 0.500.75%, 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)
The Fed’s pre-crisis operating model
IOER – FF spread drivers
* Balance sheet cost
* FDIC cost (deposit insurance cost)
* Liquidity at banks vs at GSEs/Money Market Funds
•
•
•
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
•
•
•
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.
Source: NY Fed, Bloomberg
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.
Allotted amount in the ON RRP facility in different segments
Daily ON RRP allotment (USDbn)
• 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.
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)
3%
450
0%
Fed’s bond portfolio
System Open Market Account (SOMA)
4.205bn
400
41%
350
300
0%
56%
250
200
150
100
50
0
2016
2018
2020
2022
2024
2026
2028
Agencies
FRN
2030
2032
2034
2036
Maturity
MBS
Notes and Bonds
TIPS
2038
2040
2042
2044
2046
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 outflow from prime money market funds into
government money market funds accelerated ahead of
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.
Assets under management (USDtrn)
• 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.
Source: Investment Company Institute
Prime money market fund
•
A money market fund that invests primarily in corporate debt
securities.
Government money market fund
• For more details, see The US Money Market Reform: The
Scandi Angle, 9 August.
•
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
General disclaimer
This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form
part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e.
financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect
to any such financial instruments) (‘Relevant Financial Instruments’).
The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While
reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske
Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from
reliance on this research report.
The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These
opinions are subject to change, and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related
to the information provided in this research report.
This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States.
This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any
recipient for any purpose without Danske Bank’s prior written consent.
Disclaimer related to distribution in the United States
This research report was created by Danske Bank A/S and is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of
Danske Bank A/S, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended
for distribution in the United States solely to ‘U.S. institutional investors’ as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research
report in connection with distribution in the United States solely to ‘U.S. institutional investors’.
Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research
analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the
applicable requirements of a non-U.S. jurisdiction.
Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc.
directly and should be aware that investing in non-U.S. financial instruments may entail certain risks. Financial instruments of non-U.S. issuers may not be registered
with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission.
13