Fed considers new repo tool to smooth policy exit
Comment of the Day

September 03 2013

Commentary by Eoin Treacy

Fed considers new repo tool to smooth policy exit

Thanks to a subscriber for this illuminating article by Michael Mackenzie, Tracy Alloway and Cardiff Garcia for the Financial Times which may be of interest to subscribers. The full report is posted in the Subscriber's Area but here is a section
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 bank's securities.

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 Fed's 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 Fed's 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.

Eoin Treacy's view The credit crisis forced the Fed to intervene in ways that would once have been unthinkable. The majority of commentary tends to focus on the quantity of money created, the scale of bond buying and size of the Fed's balance sheet. However, the additional powers the central bank assumed in the process of adopting quantitative easing are equally important.

As we approach the final stages of QE, the question on most peoples lips centres on how the Fed will exit its positions. The creation of new tools to retain control of money market rates suggests that even as QE is wound down, the Fed intends to hold onto the control it has gained over markets.

One of the side effects of announcing some of the tools intended to facilitate the tapering of QE has forced investors to reassess their positions. This has resulted in some of the assets that had done best during the period of extraordinary monetary easing to pull back sharply as the momentum trade has reversed. Treasuries, municipals, TIPS and mortgage REITS can all be considered part of this group.

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