(Bloomberg) -- The Federal Reserve is seen likely to lower the rate on one of its tools to help control the main policy benchmark, though some on Wall Street are skeptical about the motivation behind the move.
A plurality of strategists expect the Fed to lower the offering rate on its overnight reverse repo facility, or RRP, by 5 basis points, potentially as soon as next week when officials are widely expected to cut their benchmark by a quarter of a percentage point. The current RRP rate is 4.55%, which is five basis points above the bottom of the Fed’s policy target range of 4.5% to 4.75%.
Those expectations follow policymakers noting they see value in considering a “technical adjustment” to the RRP rate so that it’s equal to the bottom of the target range for the federal funds rate, according to minutes of the November meeting. While such a move would probably exert downward pressure on money market rates, it could also further impact funds held at the Fed facility, sparking debate on Wall Street about the benefits of such a move.
Balances at the facility, a barometer of excess liquidity in the financial system, have dropped by about $2.4 trillion since their December 2022 peak, though the pace of declines has slowed in recent months. On Wall Street, the sum of cash parked at the RRP has long been considered a useful gauge to watch as the central bank continues to unwind its balance sheet via a process known as quantitative tightening.
Barclays Plc sees aligning the RRP with the lower band as “purely technical” based on the information provided in the minutes. However, Bank of America, TD Securities and Citigroup are perplexed as to why policymakers need to undertake the adjustment now with roughly $175 billion parked at the RRP. Moreover, usage organically is expected to increase in the first half of 2025 as anticipated reductions in Treasury bill supply tied to the debt ceiling is likely to spur counterparties to park more cash at the RRP.
Officials last tinkered with the tools when it raised the rate on the RRP facility in June 2021 as a dollar glut in short-term funding markets outstripped supply of investable securities and weighed down front-end rates, despite the steadiness of the Fed’s key benchmark. At the time, there was $521 billion in cash squirreled away at the overnight RRP facility.
What the Strategists Say
Wrightson ICAP (Lou Crandall, Dec. 9 report)
- Wrightson now assume the Fed will lower the RRP rate by 5 basis points either next week or at the January meeting, though Crandall initially thought an adjustment was “probably still some months away”
- Timing of the tweak may depend on the Fed’s next policy move as the central bank could decide to split up the rate cut and technical adjustment
- Doesn’t expect much knock-on effect to unsecured rates, especially as the fed funds market almost exclusively represents overnight cash that Federal Home Loan Banks park at foreign institutions for liquidity purposes. Arbitrage spread has been flat at 7 basis points for most of the past three years and an unchanged spread on fed funds-interest on reserve balances is likely
- Sees both the Secured Overnight Financing Rate and Tri-Party General Collateral Rate dropping by 4 basis points relative to the Fed’s target range but cannot rule out a full pass-through of 5 basis points
Morgan Stanley (Martin Tobias, Dec. 6 report)
- Strategists expect RRP to be reduced by 5 basis points at the December meeting given that the adjustment is being framed as a way to bring the rate back in alignment with the bottom of the fed funds target range that had existed when the facility was established as a monetary policy tool
- Mention of a technical adjustment in the November FOMC minutes, in addition to a staff briefing on considerations related to balance-sheet management, suggests quantitative tightening and money market functioning are “top of mind”
- Fed funds rate should remain 8 basis points above the lower bound — currently 4.5% — because it’s unlikely fed funds volumes will increase to the point they would put downward pressure on fed funds
Citigroup (Jason Williams, Dec. 6 report)
- It’s challenging to estimate when the Fed would implement an RRP tweak as it’s hard to understand the motivation behind it, according to Williams. The Fed doesn’t need to implement a tweak to the RRP rate until the January meeting (or even later in 2025), if the debt ceiling is a driving concern
- If the market expected a December implementation, the SOFR/fed funds Dec/Jan futures curve would have steepened more. That would impact about 10 days this month and 25 days in January so the futures curve should have steepened by 0.4 basis points for every 1 basis point move in SOFR/fed funds, yet the curve didn’t steepen by that amount
- Whenever the Fed does decide to lower the RRP rate by 5 basis points, tri-party repo rates should fall by 5 basis points, as should bilateral rates, though the risk is only a 3 to 4 basis point move as dealers take an additional basis point or two. Fed funds will continue trading 7 basis points below interest on reserve balances (IORB) rate
Bank of America (Mark Cabana, Dec. 5 remarks)
- Not a “ton of conviction” that the Fed will tweak RRP rate in December — though likely — because “the logic of the move is quite perplexing to us” and “not clear why they want to do it,” Cabana said during a call with reporters about BofA’s 2025 outlook
- If the Fed does make a 5 basis point adjustment to the RRP rate, it’ll lower repo and T-bill rates, with the Secured Overnight Financing Rate dropping by 5 basis points and fed funds declining by the same amount
JPMorgan Chase & Co. (Teresa Ho, Srini Ramaswamy, Dec. 2 remarks)
- “Lowering the RRP rate by five basis points, that will be a way to basically bring SOFR back down to the middle of the target range,” Ho said during a media roundtable for its 2025 outlook
- “It could be that given how low RRP balances are, lowering RRP rates is not going to do much, but lowering IORB might help,” Ramaswamy said
TD Securities (Gennadiy Goldberg, Dec. 2 report)
- The Fed’s desire to decrease the offering rate on the RRP facility — potentially as early as the December meeting — could help the central bank stave off reserve scarcity “for a bit longer”
- Still expects the Fed to discontinue QT altogether in March 2025 as the RRP adjustment “is likely to be a temporary solution”
- Expect RRP rate to drop by 5 basis points and interest on reserve balances to remain steady, resulting in 5 basis point drop in SOFR and a roughly 4 basis point drop in the fed funds rate; read more
Deutsche Bank (Steven Zeng, Matthew Raskin, Brian Lu, Dec. 2 report)
- The adjustment — likely in December — would probably be aimed at two things: alleviating some upward pressure on money market rates, and facilitating further drainage of RRP balances
- Repo rates should fall after the adjustment, with “partial” pass-through to the effective rate on fed funds
Barclays (Joseph Abate, Nov. 27 report)
- “The rationale for lowering the rate is purely technical,” Abate said. “It is meant to return the rate to where it was set before the pandemic, when it was set at the bottom of the fed funds band”
- Fed is expected to keep the interest on reserve balances (IORB) rate unchanged at 4.65% so the spread between the two rates will widen to 15 basis points
- Overall, though, a 5 basis point drop in the RRP rate will lower all repo rates roughly in parallel, “but the reduction would not change market fundamentals” as balance sheet capacity is still stretched and demand for funding of all assets remains robust; read more
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