Month in Cash: What might the Fed have in reserve?
The Federal Reserve’s June announcement of an extension of “Operation Twist,” under which the Fed purchases longer-term Treasury securities with the proceeds from the sale of short-term Treasuries, was probably the most benign choice for additional stimulus after coming under intense pressure as a result of sluggish domestic economic growth and continued concerns over Europe. Since then, of course, speculation has grown that the Fed might take further steps before long to shore up the economy. Fed Chairman Ben Bernanke continues to indicate that while the Fed remains in watchful waiting mode, it is of course prepared to act to provide more accommodation—it simply hasn’t decided to do so yet, nor has it determined what steps would be appropriate, should it decide to go down that path.
Bernanke identified asset purchases and communications as the primary tools under consideration, but there are a number of different options the Fed might pursue. The current Operation Twist focuses on three-year and under Treasury securities. The Fed could expand that to include longer-dated Treasuries, mortgage-backed securities, or agencies. Judging from their discussions, they seem most interested in mortgages. That might not cause many problems for the money market world—we’d see the bizarre effect of an easing that would actually help stabilize rates, if not push them up a few basis points, if only because it would take idle supply just sitting on the Fed’s balance sheet and put it back out into the markets for use—maybe not by money funds directly, but in the case of mortgages, as collateral for repo. Another idea would be to initiate a full Quantitative Easing III, and resume purchasing securities. That option might be a possibility, but it seems it would be a distant second.
There is a third option—lowering or eliminating the Interest Rate on Excess Reserves, or IOER, from its current 25 basis-points level. Bernanke brought up this option only after a second wave of questioning by congressmen. The seemingly reluctant mention of IOER was a bit of a relief, as speculation had mounted in the past several days that the Fed might go there. The speculation was prompted by the recent action taken by the European Central Bank to lower its deposit rate from 25 basis points to zero, which was accompanied by a reduction in its lending rate from 1.0% to 0.75%. The Fed has probably observed, however, that the ECB’s current zero-rate environment isn’t working out in the way that they had hoped, pushing this option to an unlikely third.
There are, of course, concerns about European credit markets slowing down—they’re a major trade partner. But the slowdown on the European continent has already happened. It’s one of the reasons the U.S. pace has slowed. And it’s not as important of a sector for us as some other areas, such as Canada and Mexico, which are more significant trading partners. While there’s a good deal of headline risk concerning the potential for Europe’s economic problems to bleed into our markets, from a money markets perspective, we don’t see that happening just yet. They don’t have much supply—European rates are at such low levels, if not negative, that few are buying there. Europe does have the potential to impact demand. Buyers who are turned off by euro investments could swap those investments for dollar-based investments going forward, and if they’re in our markets trying to buy our securities—and there’s a finite supply—obviously rates would go down, as demand could outstrip supply. We haven’t seen that play out yet, but we’re keeping our own watchful, waiting eye on Europe.