Drop in Fed Funds Rate Fuels Talk of Tinkering: Liquidity Watch

(Bloomberg) -- The rate targeted by the Federal Reserve fell to match its lowest ever level, adding fuel to speculation that the central bank might need to tweak some of the tools it uses to control the benchmark.

The effective fed funds rate sank to 0.04% Thursday from 0.05% the day before, according to New York Fed data released Friday. That’s in line with the low reached in 2011. The drop also increases the chance that the central bank adjusts some of its tools -- the interest on excess reserves rate could be one -- to steer the benchmark closer to the middle of its target range. That band is currently 0%-0.25%.

The decline, which is taking place even as an influx of Treasury bill issuance could potentially be exerting upward pressure on front-end rates, comes as some of the recent stresses in funding markets have eased. The three-month London interbank offered rate for dollars, for example, dropped for a sixth straight session on Friday.

Related story on euro-area funding

“There is such enormous demand for front-end assets for flight to safety reasons that despite the $1.3 trillion surge of bill supply, front-end rates have continued to be pressured lower,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities. “The Fed probably wants to give themselves more room, adjusting rates modestly higher in a technical fashion.”

The current effective rate is now six basis points below IOER -- presently 0.10%. May fed funds futures indicate a rate of 0.08%, or 4 basis points above the current effective fed funds rate, which suggests traders are pricing about an 80% chance of a 5 basis point increase in IOER when Fed policy makers meet next week.

Policy makers first increased IOER and the rate on its overnight reverse repurchase agreement (RRP) facility relative to the bottom of the Fed’s target range at the January policy meeting. That month, fed funds had dipped below the excess reserves rate for the first time since 2018. Before the upward adjustment, the central bank had lowered IOER on other occasions to ensure the benchmark rate didn’t breach the top of the range.

While TD Securities strategists see the Fed raising both IOER and RRP rates at its April 29 decision, others remain skeptical. Deutsche Bank strategist Steven Zeng still expects policy makers to leave all rates unchanged because the Fed isn’t at risk of losing control over fed funds or the market drying up.

“The old reasons for adjusting IOER no longer seem to apply in the current context, and as a result we see little motivation for the Fed to hike the IOER
rate at its meeting next week,” Zeng wrote in a note to clients on April 23.

Elsewhere in funding markets, three-month dollar Libor fell 10.4 basis points on Friday to 0.88713%, the largest drop since March 9, driving its premium above overnight index swaps -- a proxy for the risk-free rate -- lower by a similar amount. June FRA/OIS also compressed but only by two basis points.

Libor-OIS should continue to narrow, but the “market-implied path into June is simply too aggressive,” NatWest Markets strategist Blake Gwinn wrote in a note, recommending investors either buy this spread or sell June Eurodollar futures outright. Strategists at Goldman Sachs Group Inc. recommended the latter earlier this week, after which the spread has tightened.

Euribor Easing

Meanwhile, the impact of the European Central Bank’s latest move to ease euro-area funding stresses is already filtering through to markets. Three-month Euribor -- the rate at which banks borrow from one another -- fell 3.1 basis points to minus 0.192%, the largest drop since 2014.

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