Rates Spark: It’s not all about the Fed today

Apart from the headline funds rate range of 4.25% to 4.50%, which will be adjusted higher by 25bp today, the Fed will also adjust higher the rate on the reverse repo facility and on excess reserves. These are currently at 4.3% and 4.4% respectively, and are often seen as the tighter corridor within which the effective Fed funds rate sits (currently 4.33%).

There is constant speculation on the likelihood for the Fed deciding to under-hike the rate on the reverse repo facility

There is constant speculation on the likelihood of the Fed deciding to under-hike the rate on the reverse repo facility to bring it to flat to the Fed funds floor (it’s currently 5bp over). The logic would be to encourage less use of this facility, which routinely takes in US$2trn in excess liquidity on a rolling daily basis. However, in all probability, repo would simply trade down to the same area, without a material effect volumes.

There is a similar argument to instead over-hike the rate on excess reserves, say by 30bp (instead of 25bp). The idea here would be to encourage a downsize in the use of the reverse repo facility in place of an upside in bank reserves (higher relative remuneration). This would allow the Fed to better manage bank reserves, ensuring that they don’t fall too fast, as they gradually ratchet their balance sheet lower through the ongoing soft quantitative tightening programme (as they allow US$95bn of bonds per month to roll off the front end).

There is a similar argument to instead over-hike the rate on excess reserves

In all probability, they won’t do this either. There is already a 10bp spread between the reverse repo window and the excess reserves, and widening that to 15bp might not make a material difference. That said, a spread of 20bp just might, and is something the Fed could consider down the line, ie, under-hiking the reverse repo rate and over-hiking the rate on excess reserves. On this occasion, there would be quite a surprise if they did anything along these lines, at least not at this juncture.

The Fed has also been quite silent on the balance sheet roll-off programme. It seems that’s the way they like it – churning away quietly in the background, and not causing too many market ripples. The big question in this space is whether the Fed could consider outright selling of some bonds off its books, and to thereby engage in a harder version of quantitative tightening. It would be huge if they did. There is certainly appetite for bonds in the market, if the recent Treasury auctions are anything to go by.

The big question is whether the Fed could consider outright selling of some bonds off its books

However, such selling of bonds outright would likely be a step too far at this juncture, as it would likely generate a tantrum. But it's always there should the Fed start to feel the fall in longer-dated market rates is acting contrary to their hiking efforts on the front end. Even a mention that they are looking at this down the line would have a material effect. Not expected, but these are potential market movers that we need to cross off as the meeting outcome unfolds.

Importantly, any mention of potentially upsizing the bond roll-off in the future or considering any bond selling (eg, of the longer-dated mortgage portfolio) would signal they were uncomfortable with where longer-dated market rates are at.

We started the week by saying that investors are increasingly relying on their own analysis of economic data, rather than on central bank guidance, to form their opinion about the direction of monetary policy. This is still true. Even in the run-up to tonight’s Federal Open Market Committee (FOMC), and tomorrow’s European Central Bank, meetings, data should play a greater role in shaping policy expectations, and the direction of interest rates.

Central banks are purposefully behind the curve

One of the reasons is that central banks are purposefully behind the curve. Their past mistake in anticipating the inflation surge means they’re unlikely to acknowledge it is going back to target until they have a much higher degree of confidence than now. The other reason is that markets are correctly priced for the next few meetings. We anticipate 50bp more hikes from the Fed, the curve is pricing 58bp, and 125bp from the ECB, where the market is pricing 150bp.

Where the debate gets more interesting, from the point of view of rates markets, is when one forecasts what will happen next. For the Fed, today’s employment indicators (job openings and ADP) will determine how much credence the market gives its ‘higher for longer’ stance. So far, Fed communication isn’t a success: the curve is pricing almost 200bp of cuts by end-2024. This is despite one having to look very closely at data to see the cracks forming in the labour market. Any change in this state of play could have the curve price even more cuts.

Fed communication isn’t a success: the curve is pricing almost 200bp of cuts by end-2024

As things stand, we expect the ECB to be more successful than the Fed in pushing back against rate cut expectations, but they may well be given an assist by today’s eurozone inflation print. This month’s release is proving even more difficult than usual to forecast due to the annual re-weighting of components, and due to Germany delaying its own release until later in February. Spain’s inflation surprised to the upside, France’s didn’t, so markets are none the wiser about today’s release.

These releases point to choppy trading without much direction into the key central bank meetings, but they may well shape the way markets react to their tone. Our hunch so far is that investors would be minded to fade any jump in rates on a hawkish FOMC, while a hawkish ECB would be more credible and push euro rates higher, especially at the 5Y point.