UBS: Fed realizes a reverse repo program isn’t the answer

Dudley pointed out rises won’t start until well after the program is over but Plosser termed the banks liquidity reserves a time-bomb since the organism may need to rise rates quickly forced by increasing inflation.

It is possible that, by the end of this year, the unemployment rate has declined to near the Fed’s 5.4% estimate of NAIRU and inflation has risen to or above their 2% target. With the Fed potentially fulfilling its mandates but rates at zero and the balance sheet still quite large, the ability of the Fed to effect a timely exit from its highly accommodative policy could be questioned. UBS analysts believe the continued lack of an articulated exit strategy could harm Fed credibility and prompt an increase in market volatility and rates as early as this quarter.

UBS comments are as follows:

The minutes of the June 17-18 FOMC meeting suggest that the Fed has finally come to realize that a reverse repo program is unlikely to be the answer to the exit strategy.

Using reverse repos to drain liquidity is unlikely to absorb enough liquidity to allow the Fed to restrain lending activity and could disrupt other funding markets, increasing demand for bank loans. The Fed appears to have finally reached the same conclusion. As a consequence, their ability to significantly drain liquidity from the banking system using repos appears limited. Instead, they noted that “[m]ost participants agreed that adjustments in the rate of interest on excess reserves…should play a central role during the normalization process.” However, we believe even this policy tool will not prove as useful as hoped.

The ability of the Fed to pay interest on reserves (IOR) is expected to play a key role in any exit strategy. We agree. However, the problem continues to be that, with more than $3 trillion in excess balance sheet, the Fed is no longer the marginal supplier of reserves, able to set the price as they see fit. Instead, to exercise control over rates they need to absorb significant liquidity and, as such, they have moved from a price setter to a price taker. If the economy is strong enough and loan demand growing, they will be in competition for the funds that they are attempting to absorb, resulting in higher rates than they may have hoped.

The minutes of that meeting noted that “Participants also discussed the appropriate time for making a change to the Committee’s policy of rolling over maturing Treasury securities at auction and reinvesting principal payments on all agency debt and agency MBS…” However, the debate over prepayments is a red herring. 13 of 16 FOMC members noted that they viewed 2015 as the appropriate year to begin a Fed tightening cycle. Thanks to the “success” of the “Maturity Extension Program” (colloquially “Operation Twist”), there is only $3.5 billion in Treasury debt held by the Fed maturing and only $5.7 billion of Agency debt in 2015.

The $9.2 billion represented by this debt represents just 0.2% of the Fed’s portfolio. So, the debate about whether to end rollovers and reinvestment of these holdings is a debate about signaling, not an actual tightening of policy of any significance. Indeed, even in 2016 the maturing amount rises to just $232 billion, dips back down to $206 billion in 2017 and then jumps to $371 billion in 2018. These figures assume the Fed would allow 100% roll-off, which seems a bit of a stretch given the needs of the Fed’s securities lending program and the recent “specialness” of on-the-run Treasury securities. After all, market functioning will be important as the Fed moves to exit.

Similarly, of the $1,634 billion of Agency MBS, less than 6% of the MBS has a coupon of 5% or above, suggesting only a modest prepayment speed. Given that eliminating the reinvestment and rollover program would be a function of a tightening of policy and that tightening of policy would likely be accompanied by higher mortgage rates, it seems unlikely to us that we would see prepayment speeds in excess of 10-15%. While $160-$250 billion is a significant sum, it also requires both a functioning market away from the Fed (i.e. the creation of new mortgages or refinancing activity) AND a willingness by the Fed to risk weakening the housing market.

We expect the order of events regarding reinvestment and rollover, which is likely to occur only after the Fed has moved to raise rates, is first: Announce rollover limits of maturing Treasury debt. Second, reduce reinvestment of MBS holdings. Finally, eliminate reinvestment of MBS holdings.

 

To avoid an unwelcome increase in market volatility, we believe the Fed needs to articulate a credible exit strategy well in advance of when the market believes one is necessary. Failure to do so could spark an inflation expectations-induced rise in rates which could prove difficult to contain if the Fed continues to assert that the rate hike cycle can be slower than normal with a lower terminal rate despite the size of the balance sheet. We believe that the Fed should admit that the large balance sheet implies a higher Fed funds rate is necessary to achieve any given degree of tightening (see chart, previous page). Also the Fed should articulate that  the rate hike pattern will be at least as rapid as has been the case historically as a consequence (an admission they are only grudgingly making as they increase the implied amount of tightening in 2016 as they update their rate hike forecasts). The near-term market reaction may be negative but, we believe, the longer-term boost to Fed credibility caused by this admission would prove a net benefit over the medium to long-term.