Rates Spark: Weighing hawkish risks

The general expectation – and ours - going into this week’s FOMC meeting on Wednesday evening is that policymakers will want to avoid rocking the boat after having engineered a relatively calm second quarter for financial markets. Taken at face value, that should benefit carry driven trades and put longs in US rates, especially in the belly of the curve i.e. around the 5Y point, in the driving seat. This explains part of the recent strength in rates markets.

Policymakers will want to avoid rocking the boat

However, being confronted with more and more headlines surrounding the acceleration in prices in particular, the latest of which a NY Fed consumer survey that also sees medium term price expectations on the rise, it appears warranted to take a step back: If there is a chance that also the Fed acknowledges these developments in its discussions, the risks out of this week’s FOMC meeting are tilted to the hawkish side.

The risks out of this week’s FOMC meeting are tilted to the hawkish side

Indeed, a Bloomberg survey shows that the expectation among economists is that enough FOMC members will shift their forecast of the Fed funds rate so that the median forecast - the Fed's “dot plot” - will show a first hike in 2023. It is not surprising that the 5Y sector, despite offering the most carry on the curve, has lagged yesterday, and measured by the 2s5s10s fly the belly has priced out much of its richness recently.

A key question from the Federal Reserve meeting revolves around any adjustment that they could choose to make to help ease the dramatic build in liquidity that is returning to them through the reverse repo window. The fact that it is now in excess of half a trillion is not a massive issue in itself, the bigger issue is what it implies about the totality of circumstances on the US money markets, an area that is right in the focal point of the Fed’s remit of control.

While the Fed does not pitch rates negative, and the effective fund rate is steady at 6bp, the front of the money market is certainly printing negative, as can be gleaned from bills. The cash going back to the Fed is coming mostly from non-banks, and typically money market funds that need to post it somewhere. Borrowing bonds from the Fed to post at 0% is the trade to set. Lending cash to borrow bonds is effectively a carry play, but it is a stressed one.

More important for the Fed will be the perception that it has control.

More important for the Fed will be the perception that it has control. If the Fed feels comfortable supplying collateral and taking in cash, then that's fine. But if the Fed feels something must be done, there are a few options. One could be to mop up the liquidity through bills issuance. This is best coming from the Treasury. The problem here is the Treasury wants to reduce bills issuance, partly as it is a policy objective to do so (as it is already quite high). But also as an end-July debt ceiling date looms, and the Treasury has no choice but to prepare for a near miss.

The alternative is to coax up front end rates, so that money market funds have somewhere else to post cash. That would likely point to raising the rate at the reverse repo window (currently 0%) and the rate on excess reserves (currently 10bp). At the moment, the former is more relevant than the latter, but to really coax up rates with success, it would likely require a rise in both. We have long argued that this could be the way to go, and if it is done it should be for 10bp rather than a tame 5bp, as the latter is not likely to solve much.

It would be posted as a technical adjustment, with no implication for wider policy. In its purest sense it of course would be a tightening in policy, but the point would be that it would mean nothing for the fed funds range of zero to 25bp which is the direct policy objective of the Fed. Will the Fed do it? It’s a close call. But there is a risk that they do it and it changes nothing, in the sense that the reverse repo window remains as popular as ever. We don’t have a conviction call here, but if the Fed does anything at all at this meeting, it will be here.

European markets already have the ECB’s renewed backing with its pledge to continue buying at a faster pace for the coming quarter. This should keep a lid on market volatility, but given the lower starting point of EUR rates we doubt that the ECB can prevent a gradual increase in interest rate levels and (re-)steepening of curves as the economic recovery gains further traction.

More issuers could use the relative calm ahead of the summer break

More technical factors could play into that dynamic. For one more issuers can be anticipated to use the environment of relative calm created by the ECB to raise funding ahead of the summer break. Most prominent issuer is the EU, that has yesterday mandated the first transaction to finance the EU’s recovery fund (NGEU). It will be a 10Y bond with the size expected to be at least €10bn, and two more deals have been flagged for the period June/July which should already constitute a good portion of the €80bn in total foreseen for this year.

Lower market liquidity conditions over summer usually meant slowing QE

The other factor to consider is to what extent the ECB will be able to live up to its promise of buying at a faster clip, given that lower market liquidity conditions over summer have usually meant in the past that the ECB would reduce its purchases by up to 30%. While officials have flagged the issue, and lower market liquidity would usually also imply a greater impact per unit purchased, the danger of a wrong signal being sent remains. As if foreshadowing of what is to come, weekly purchases under the ECB’s Pandemic Emergency Purchase Programme have dropped to below €11bn, the lowest since January. Of course, the important caveat is that the weekly figures are often distorted by bond redemptions – and last week saw a €14bn German bond come due of which the ECB likely held a good chunk as well.