Fed Seen Facing Hard Choices to Keep Control of Overnight Rates

(Bloomberg) -- U.S. overnight markets are poised to tighten through year-end, putting pressure on the Federal Reserve’s operating framework and forcing officials to make adjustments to keep rates within their target range, according to Credit Suisse Group AG analyst Zoltan Pozsar.

As short-term funding rates continue to trade above the top of the central bank’s policy band, the Fed has a “waterfall of options” it can use to exert control, the former U.S. Treasury adviser wrote in a report Thursday.

Choices include a reverse twist where the Fed sells longer-dated Treasuries from its portfolio and buys T-bills on the open market; slashing the interest on excess reserves, or IOER, rate until it converges with the central bank’s overnight reverse repurchase agreement rate; prematurely ending the balance-sheet unwind; or even unveiling an overnight repo facility.

The viability of the Fed’s normalization efforts and its broader toolkit are being tested as surging Treasury-bill issuance and the central bank’s balance-sheet unwind flood the market. That’s pushing short-term rates -- from overnight repo to one-month T-bills -- above the Fed’s 1.75 percent to 2 percent target range and risks gumming up the workings of monetary policy.

Fed Seen Facing Hard Choices to Keep Control of Overnight Rates

“This is a risk the Fed will strongly prefer to avoid,” Pozsar wrote. “Changes will soon be necessary to the framework to ensure that overnight rates continue to print within the target band.”

So far, the Fed’s response to the upward drift in rates has been to lower the IOER rate relative to the upper bound of its target range, the central bank’s “preferred method of dealing with pressure” on overnight rates, according to Pozsar. The technical adjustment lowered the spread reserves pay relative to T-bills, which would incentivize banks to mop up the additional supply.

But since the IOER cut in June, banks have only bought about $10 billion in Treasury bills, while increasing their lending in the repo market by roughly $35 billion, according to Fed data. This suggests that the 5 basis point adjustment “didn’t do the trick and more cuts will be necessary,” Pozsar wrote.

Mark Cabana, head of U.S. Short-term interest rates at Bank of America, expects another tweak by December.

Reverse Twist

Even if additional IOER cuts don’t prove effective, Pozsar says the Fed could “go back two steps” and reconsider reverse twisting its balance sheet, or capping the rate on its foreign RRP pool, which would push global institutions back to the T-bill market.

However, if the Fed continues to slash IOER until it converges with the rate on the RRP facility, an introduction of an overnight repo operation is inevitable as it “will be necessary to police the top of the Fed’s overnight target range,” Pozsar wrote.

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