If you thought the Fed’s biggest headache heading into today’s rate decision was the sudden dust-up in Saudi Arabia, well think again. In addition, to the impact of higher oil prices from the Saudi refinery damage, and the geo-political ramifications of the attack, you can add a more mundane but still important issue of overnight funding. The usually quietly overnight repo market suddenly crackled with volatility on Monday and Tuesday as a confluence of events forced overnight repo rates above 8%. While corporate tax payments, settlements on Treasuries auctioned last week, and continued shrinkage of the Fed’s balance sheet are all being touted as reasons behind the surge in overnight rates, it forced the Fed to conduct its own overnight repo operation for the first time in a decade to settle markets. The incident is likely to force the Fed to begin growing its balance sheet again as reserves have obviously fallen to levels that have revealed cracks in the plumbing of overnight funding. That growth will boost Treasury prices at the margin as the Fed re-enters the secondary market. Apart from those concerns, we take a look below at what we expect with today’s Fed rate decision.
- First, and coming as now surprise to anyone, we think the Fed cuts 25bps but it will come with the same two dissents as the July rate cut: Boston Fed President Eric Rosengren and Kansas City Fed President Esther George. The possibility of a third dissent rises which would put additional pressure on Powell if plans are afoot for additional cuts. Plus, with the repo incident, expect a 30bps cut to the IOER to 1.80% in order to try and force excess reserves to other overnight markets.
- Second, we think the updated dot plot matrix will project another cut before year-end but that may be it for rate cuts in the forecast. If the Fed’s characterization of the easing cycle as a “mid-cycle adjustment” is to be believed they are probably using the last such “mid-cycle adjustment” in 1998 when they cut a total of 75bps before resuming rate hikes. One more cut after today’s would get the Fed their 75bps in rate cuts.
- Third, the dot plots and Summary of Economic Projections will be scrutinized for any adjustment to the Fed’s estimate of the neutral rate, or the rate they think is neither accommodative nor contractionary. The June forecasts cut it from 2.8% to 2.5%. Given we are in the midst of a “mid-cycle adjustment” of rate cuts another downtick in the neutral rate estimate could be in the offing but given only one Fed member had it lower in June (at 2.375%) that might be a bridge too far at this meeting.
- Fourth, the economic forecasts are likely to remain relatively unchanged from June. That is, 2.1% GDP for 2019, 2.0% for 2020, and 1.8% for 2021. Inflation rates are likely to be unchanged too around 2.0%. No hint of a recession will be found in the forecast.
- Fifth, while Powell has “out-doved” market expectations at all but one meeting this year, he’ll be hard-pressed to pull that dove out of the hat again. Fed funds futures are calling for two more cuts this year (today and either October or December), which is likely what we get, but next year fed funds futures are expecting another 36bps in cuts. That will conflict with what we expect will be the Fed’s projection of no 2020 cuts. That is likely to lead to a bearish flattening in the curve with selling of Treasuries on the short-end and rallies on the long-end as the market sees a policy error on the horizon.
And circling back to our opening, the dramatic increase in overnight repo rates in the middle of September has to worry the Fed. While it may have been a confluence of idiosyncratic events that conspired to lift overnight rates from the mid-2% range to above 8% it still reflects a market lacking excess dollars.
Unabated, that activity would have spilled-over to the Fed funds market as lenders there see the yields available in repo and shift to that market and thus force fed funds rates higher and most likely above the Fed’s current range of 2.00.%-2.25%. That’s why you saw the Fed step in for the first time in more than a decade with an overnight repo operation totaling $53 billion that alleviated the dollar shortfall (and they added another $75 billion today). What this illustrates is that while the Fed has been slowly shrinking its balance sheet, and draining reserves from the banking system, they seem to have hit the limit of such drawdowns as the repo market actions so abruptly signaled.
This is likely to lead the Fed to begin adding to its balance sheet by buying Treasuries and replenishing the level of reserves in the banking system. The repo incident will encourage the Fed to begin offering a standing repo facility which will also encourage investors to own Treasuries as they will become a source of liquidity at the Fed. Both of those developments are likely to aid the bid in Treasuries at the margin and continue the lower-for-longer in yields. In any event, we’ll be back later this afternoon with a recap of the FOMC meeting and the policy decision.
Overnight Repo Rates Spring Higher Before Fed Reacts
A sleepy corner of the funding market crackled with volatility over the last two days and that had to generate concern at the Fed. Typically, overnight repo rates (borrowings secured by Treasury collateral) trade near the established fed funds rate; however, a confluence of events on Monday and Tuesday created a shortage of reserves (aka dollars) versus a surfeit of collateral needing to be funded. That led to overnight rates leaping over 8% before the Fed stepped in with their own overnight repo for the first time in years. While the Fed has been shrinking its balance sheet, and hence reserves, it may have reached its limit. Expect a repo facility to be initiated by the Fed as well as balance sheet growth. Both will be positive to Treasury prices.
Agency Indications — FNMA / FHLMC Callable Rates
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