Fed considers new repo tool to smooth policy exit - FT.

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August 29, 2013 11:57 am

Fed considers new repo tool to smooth policy exit

By Michael Mackenzie, Tracy Alloway and Cardiff Garcia in New York

Reuters

Ben Bernankes parting gift to the bond market may well end up being trillions of dollars of high-quality securities

Ben Bernankes parting gift to the bond market may well end up being trillions of dollars worth of high-quality securities that could ease concerns over an impending collateral shortage just as the Federal Reserve raises overnight interest rates. At a time when investors are focused on how the US central bank will end its grand experiment with years of loose money, last weeks release of the Feds meeting minutes for July show it is entertaining far-reaching changes for how future monetary policy will be executed. Policy makers were briefed by Simon Potter, head of the markets group at the New York Fed, about establishing a fixed-rate, full-allotment overnight reverse repo facility. This would operate alongside the Feds existing reverse repo facility that is designed to drain the vast amounts of excess reserves from the financial system when official overnight rates start rising.
Treasury repo and US federal funds

The new central bank tool for the day when a tightening of policy beckons has the potential to change the fundamental structure of short-term lending markets; alleviate collateral scarcity; reinforce the push for simpler bank capital regulation; and approximate a Fed backstop for big swathes of US money markets. It is a potential all you can eat collateral buffet, says Joseph Abate at Barclays. Since the trade is fully collateralised and with the Federal Reserve, it will establish the overnight risk-free rate for the economy. For the past two years, market participants have fretted over a shortage of collateral in the financial system, with estimates of the deficit ranging from $500bn to as much as $10tn. Banks and other investors use collateral to lubricate the wider financial system, but a host of recent developments have reduced its availability. The Fed itself has mopped up billions of dollars worth of high-quality collateral through its bond-buying programme, known as quantitative easing, in exchange for cash which banks can park at the central bank in the form of overnight deposits. When the Fed begins to exit its unconventional policy it will probably seek to raise the overnight rate it pays banks, currently at 0.25 per cent. In doing so, it will also hope to increase a variety of short-term lending rates in the wider markets. Those rates, such as the effective federal funds rate and repo rates, have been meaningfully lower than the interest paid on bank reserves for the past few years. The clamour for high-quality bonds even threatens to pull the Treasury repo and bill rates into negative territory, hindering the central banks exit efforts. Analogous to a coiled spring, the larger the QE efforts the lesser the control central banks may have on the wedge between repo rates and their policy rate, Manmohan Singh, an economist at the International Monetary Fund, writes in a new paper. The Fed has previously said it plans to use reverse repos to drain excess reserves by allowing banks and money market funds to bid on the central banks securities.

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Fed considers new repo tool to smooth policy exit - FT.com

http://www.ft.com/intl/cms/s/0/3c563ba8-0f22-11e3-8e58-00144feabd...

But new rules which hinder the ability of banks to lend out those securities into the wider market could damp demand for these transactions and complicate the Feds exit. Reverse repos will be contingent on balance sheet space at banks and nonbanks [such as money market funds and government sponsored enterprises like Fannie Mae and Freddie Mac] amid a tighter regulatory environment, says Mr Singh. The new full allotment tool means a wider range of investors could lend as much cash as they wish at a fixed rate, determined in advance by the Fed. In return for lending cash, these investors would temporarily hold high-quality collateral. That trade-off should give the Fed greater control over market rates and help the central bank converge the effective fed funds rate, general collateral repo rates, corresponding Treasury bill rates, and bank commercial paper rates, with the overnight interest rate paid on reserves placed at the central bank. Such a facility could have a significant impact on money market rates and could also simplify the Feds exit strategy, as it would drain reserves from the banking system and tighten the link between market rates and the rate paid on bank reserves, says Brian Smedley, at Bank of America Merrill Lynch. For now, markets are still digesting the potential impact of the new monetary tool, and trying to work out just how big a collateral spread the central bank might serve up. One market participant, who declined to be named, warned that the new tool risked further distorting the independence of markets in favour of greater Fed control. If it is a narrow attempt to put a floor under the funds rate, it may not drastically alter the availability of funding in the repo market, says Lou Crandall at Wrightson Icap. If it is a broader effort to unify the market for bank reserves with the market for other high-quality liquid assets, the disintermediation effects will be much broader.

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