Only two words changed in last week’s Federal Reserve’s statement from the previous one, but those in the liquidity markets had plenty to digest in the form of the accompanying Implementation Note. It’s the very definition of inside baseball, but its announcement of an increase in the rate on the reverse repo facility and the interest on excess returns (IOER) has wider implications.
The change is all about control. Policymakers want the rate for overnight transactions to be within the current fed fund’s 1.5-1.75% bound. They raised IOER from 1.55% to 1.60% and reverse repo from 1.45% to 1.50%. It’s a bit like the bending the wire coat hanger analogy. Transaction rates moved higher in the summer, so regulators pushed the two rates lower. With the Fed’s massive injection of liquidity into the system starting in September, these rates slipped and now it is shifting them in the other direction.
The level of bank reserves at the Fed play a role, too. Chair Powell is rumored to want to see them reach approximately $1.5 trillion. Practically speaking, that will probably require getting to around $1.8 trillion near the corporate tax date of March 15 when companies will pull $300-some billion out and then again on April 15th for individual tax day. The corporate tax date was a factor in September and policymakers don’t want to see that again. They are addressing the issue through open market operations, both temporary at least through April and permanent (buying Treasury bills) into the second quarter.
All of this begs the question, do Fed policymakers know what they are doing, or are they just throwing things against the wall to see what sticks? In our opinion, it’s both. They are trying different things in a responsible way. These are minor adjustments, fine-tuning to see if they get the Fed closer to being able to leave the scene, so to speak. Yes, the moves last week are not typical for a central bank, but what has been in the last decade or so? Certainly not quantitative easing, a range versus a rate, a floor for overnight trading, negative rates, etc. By the by, negative rates are very unlikely to ever come to the U.S. The arrow for the economy points up, not down. The labor market is solid, housing has made a nice rebound, manufacturing is still subpar but not getting worst and trade negotiations seem to be heading in the right direction. The Fed now needs to find a graceful way to bow out of its proactive intervention.
We are trying to make purchases in the long end of the money market yield curve to buoy our weighted average maturity range of 40-50 for prime and tax free funds, and 35-45 days for the government funds. The Treasury yield curve is essentially flat in the 1- to 6-month space. But the London interbank offered rate (Libor) still has a fairly positive slope up to one year. That’s good news. The problem is that securities are being issued below Libor, making it hard to find instruments with the expected yield. It’s a seller’s market. That, too, should bend back.