Fed May Act If U.S. Short-End Rates Slump Toward Zero, BofA Says

U.S. short-term market interest rates appear poised to collapse toward zero during the first half of 2021 because of a supply-demand imbalance, an outcome the Federal Reserve is likely to take action against, Bank of America Corp. strategists said.

The combination of a big increase in bank reserves as the Treasury Department spends down its near-record cash balance, and a steep drop in the supply of Treasury bills has the potential to push repo and other short-term market rates toward zero, Mark Cabana, head of U.S. rates strategy at Bank of America, and Olivia Lima wrote in a report Thursday.

With the fed funds target sitting in the 0% to 0.25% range, the Fed won’t want policy rates trading in negative territory so as to avoid distorting market functioning due to complications with the effective zero bound, the strategists said.

Fed May Act If U.S. Short-End Rates Slump Toward Zero, BofA Says

They lay out a number of actions the Fed could take in response:

  • Increasing the interest on excess reserves (IOER) rate and possibly the overnight reverse repurchase (RRP) rate
  • Expanding access to the overnight RRP facility
  • Selling short-dated Treasuries outright via open-market sales or allowing maturing bills to roll off

The Fed “will be the first line of defense,” but the Treasury Department could also get involved by running a higher longer-run cash balance, or by tilting issuance toward bills and away from long-dated coupons, the strategists said. The Fed and the Treasury “have adequate tools to keep front-end rates above zero, but do not expect them to act until markets force them.”

Trades that would benefit from such a scenario include a long position in March 2021 SOFR futures and owning 2-year Treasuries vs OIS, they said.

The driving forces behind the expected decline in Treasury bill supply -- which nearly doubled this year to about $5 trillion and could decline by $500 billion to as much as $900 billion -- include limited fiscal stimulus, elevated coupon issuance and an expected decline in the Treasury cash balance as spending is unlocked by stimulus legislation, the strategists said.

©2020 Bloomberg L.P.

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