Not so smooth
It's time for the Fed to raise overnight rates.
Everyone knows you shouldn’t try to time the market. Even traders should look for value, not arbitrage. So why are Federal Reserve policymakers, of all people, doing just that with overnight rates? In the Federal Open Market Committee's meeting last week, they passed on the opportunity to raise at least one of the Fed's administered rates, a move that likely would have alleviated the strains on the front end of the yield curve.
The reverse repo program (RRP) helps the Fed control how big banks, asset managers like Federated Hermes, government sponsored entities and others price overnight transactions. The repo market exists to connect participants who need cash with those who have excess funds. The Fed wants this to go “smoothly,” so it offers a “floor” rate to counterparties to incentivize financial firms to lend if market rates are too low. But the overnight market hasn’t been smooth for some time now. By setting the RRP at zero, all the Fed has accomplished is preventing trades with negative rates. That’s important, of course, but not much incentive and not much good to end investors.
The Fed already said it is willing to raise the RRP rate (and also the interest paid on excess reserves, IOER). It even raised the counterparty limit on usage of the facility from $30 billion to $80 billion in anticipation of heightened demand. But it seems inclined to wait until stress is at its worst because the fed funds rate—an extremely thin market—is still at an acceptable level.
We think the time has come and the dithering is inappropriate. With demand for Treasury bills high amid low supply and increased participant dependence on the RRP, it’s clear the overnight market is challenged by technical forces. A bump in the RRP would go a long way to normalizing it.
With the recent surge in retail sales and jump in gross domestic product growth, you would think the commercial paper market would be robust. But issuance has been flat, which tells us that the spike in bonds many companies offered in 2020 for insurance as the economy tanked has left them flush with cash. As the recovery gains more steam and inflation creeps up, we anticipate more paper to be issued.
Concerning inflation, it is curious how the market keeps trying to lead the Fed. While price pressures are increasing and many consumers are itching to spend stimulus checks, the Fed has been deflecting every suggestion of tightening. Investors don't seem to believe that the Fed wants the economy to be piping hot and that it considers the recent rise in activity as lukewarm. We think it could start to taper purchases this year, but no indication yet. These days, the Fed seems happy to make everyone wait.
One note on the new Bloomberg Short-Term Bank Yield Index (BSBY). The industry has been waiting for a firm to issue a security tied to it, and Bank of America did so in April. No money funds bought it, but it was taken up by a Local Government Investment Pool and some other lenders. As the index grows in usage, our expectation is that we and the industry will participate regularly. The International Organization of Securities Commissions blessed it last month, so it is chugging along on the track to becoming the index that prime funds will use to replace the London interbank offered rate (Libor).
Industry-wide, government money markets grew slightly in April, while prime and tax-free funds faced modest outflows. We kept the weighted average maturities of our money funds in target ranges of 35-45 days for government and 40-50 days for prime and municipal.