Rates Spark: Setting a course for change

With respect to the fall in market yields, the Fed notes policy communication, investor positioning and the pandemic as driving factors. There was no particular role noted for the macro economy, or any data impact. Rather the Fed preferred to focus on the technical explanation of a fall in the term premium reflecting the above-mentioned factors. There was not much more discussion beyond that on why rates are where they are or to what extent they signal anything if at all.

What will be a factor ahead is the need for higher market yields so that the Fed has room to ultimately hike

What will be a factor ahead is the need for higher market yields so that the Fed has room to ultimately hike rates in the coming years. This is not for the here and now, but it is something that will be on the radar once the taper is complete, which on our interpretation of events would be around the middle of next year. So, to facilitate that, we argue that there needs to be a tantrum. If the Fed has a taper announcement and/or taper and there is no tantrum at all, that in fact is a problem for the Fed. The Fed may not have said it, but they will be aware that this is an issue.

The Fed minutes contained some interesting discussion on the Fed's permanent repo facility. This is a new facility, one that effectively allows the market to generate reserves by posting collateral at the Fed. In simplistic terms it makes bonds equal to cash for eligible counterparties, which is significant. It's not relevant for the here-and-now of course, as the market is long reserves and short collateral - hence the USD 1trn of excess cash going back to the Fed on on a daily basis on the reverse repo facility.

The permanent repo facility will allow the market to post excess collateral (or just collateral) for cash.

In contrast the permanent repo facility will allow the market to post excess collateral (or just collateral) for cash. This will become more important when the Fed completes its tapering process, and really becomes relevant should the Fed decide to take reserves out of the system by lowering it's holdings of bonds (whether slow grind: not re-investing in roll-offs, or fast track: actual bond sales).

There was some discussion around the USD 500bn limit to the facility, and whether such a cap was necessary. The was also a counterparty limit set at USD 60bn, but there was less discussion on this. There was general support for the facility, although one member would have preferred access to foreign players to be made available during periods of market stress, rather than through a standing facility.

Ultimately the permanent repo facility should help to make for a less spiky market for short term rates, allowing the Fed more control over the repo market, or in a sense provide the market with the means to control it independently.