RBC Capital Markets takes an interesting take on the Fed’s newly released Fed Funds projections.
First the projections, which look like this:
As the note under the chart declares, each circle represents an individual FOMC member’s judgment of where Fed Fund rates should be at the end of the specified year.
So while the main thrust of Wednesday’s FOMC statement was dovish due to the Fed’s decision to extend the low-rate commitment to at least late-2014, the projections themselves were much more hawkish.
RBC’s head of US rates strategy Michael Cloherty and its chief US economist Tom Porcelli explain it as follows:
First, FOMC members’ Fed funds projections were very hawkish, with three calling for tightening in 2012, three more calling for tightening to begin in 2013, and another two whose 1% year-end 2014 forecast suggests tightening to start before “late-2014” (we assume the Fed will move 25bps every other meeting in the early stages of the tightening cycle, as the market will be extremely fragile as it comes off of 0% rates).
That is eight forecasts that are inconsistent with the late 2014 language—even the median forecast of 75bps is barely in line with “at least through late 2014”.
There are two conclusions. First, everyone must be cautious about overanalyzing the Fed funds projections, as not every participant’s projection carries the same weight in forming policy. And second, for the same reason, investors should use caution in trading based on comments from any Fed member other than Bernanke, Yellen, or Dudley.
In other words, some FOMC members are more equal than others.
But the RBC men go on to make another very interesting point. Projections like these can now be used to anticipate repo-market moves. And from that point of view Cloherty and Porcelli are a little concerned about what the prescribed exit path could do to repo markets.
As they note (our emphasis):
Keeping rates pinned for at least an extra 15 months is clearly positive for intermediate rates. Yet, if we assume there is 100bps of tightening in 2015 (25bps every other meeting) and 200bps of tightening in 2016 (25bps at every meeting), this would leave Fed funds at a still-low 325bps at the end of 2016.
Also, we should expect repo rates to rise faster than Fed funds over this horizon. The Fed will do a massive amount of reverse RPs as part of its exit process.
In addition, Treasury supply is likely to rise by another $5+ trillion while the money market fund industry shrinks (regulatory reform remains a major headwind), so at some point the money fund industry will stop being the marginal price-setter in the Treasury repo market with the next buyer coming in at significantly higher rates.
Together, these effects make us think that financing rates should average a bit more than 70bps over the next five years. Even with an extremely thin term premium, to get 5s to trade below the mid-70s we will need news that reduces tightening expectations four and five years from now. Nonetheless, low and stable 5yr rates suggest that investors will grab for yield in highly rated assets—covered bonds, SSAs, etc. should perform well in the coming months.
In other words, while repo rates have had a tendancy to under-run Fed Funds rates (quite significantly leading into the crisis), the amount of reverse repos that will have to be done in order to lift rates in line with the projected path (and in the face of growing Treasury supply and a diminished money market industry), will very likely see repo rates overshoot Fed funds rates from then on.
This is quite a unique state of affairs.
Now, if the Fed was to include QE asset sales as part of its exit process as well, the effect on markets could be even more extreme. In fact, according to Cloherty and Porcelli, it could have a greater impact than the QE purchases had in the first place.
Anticipation of this prospect, meanwhile, could now come to compromise the Fed’s current curve-flattening agenda.
Indeed, as the analysts note:
In the Q&A, the Chairman mentioned that the Fed could start asset sales in 2015. This suggests increasing recognition at the Fed that there is no way to quickly drain all the reserves that QE has created without selling (reverse QE). And this creates limitations on how flat the curve can become due to QE.
We think that, in an environment where the Treasury is issuing more than $1T of net supply every year, asset sales will have a much larger price effect than asset purchases.
So if we know that rates will be driven higher in 2015-2017 due to asset sales, we should find sellers if forward rates fall too far. In order for asset purchases to drive forward rates sharply lower, the Fed needs to buy so much that arbitrageurs do not have the capacity to offset the flow. In essence, the Fed needs to overwhelm the liquidity of the Treasury market in order to drive forward rates significantly lower, which is a very dangerous game.
That’s to say, a more pronounced understanding of the Fed’s exit plans could run the risk of skewing everything.
What’s more, if repo rates were to run significantly above effective Fed funds from now on… that could have unexpected and potentially inflationary consequences.
After all, secured funds should not technically trade above Fed funds (at least, in a balanced market). In a situation where you can borrow more cheaply unsecured than secured, it seems quite natural that the mythical money multiplier might stage a comeback.
Although inflation would only become a problem if and when bondholders started to fear that the value of their Treasury holdings was about to be compromised — perhaps due to the expectation that the Fed was about to dump its stock — and started moving into anything but government debt.
Which leads us to the following conclusion from a research paper by Seok Gil park entitled “Central Banks Quasi-Fiscal Policies and inflation“, which looks at the potential unintended consequences of balance sheet expansion, including the idea that QE reversal might be an actual catalyst for inflation:
For example, suppose that a central bank with a negative capital suffers additional losses from long-term bond holdings while the central bank tries to increase short-term interest rate in response to inflationary pressure. As the real value of holding the central bank’s net liability falls below the equilibrium with the negative return shock, then the private agent tries to decrease holdings of the central bank’s liability (nominal money balance) and increase consumption. In the end, the general price level increases, and the central bank passively increases nominal money supply in order to satisfy real money balance demand
Paradoxically, the hike in the policy rate (deflationary monetary policy) induces inflation in this case. In other words, the central bank is confined to a situation where it cannot play an active role in stabilizing inflation. Since fiscal support of the central bank’s balance sheet precludes such type of equilibrium, therefore, the fiscal authority’s back-up is a pre-condition for effective monetary policy when the central bank is engaged in the other policy role such as maintaining financial stability.
———————
Notably, the contractionary monetary policy shock induces inflation when the central bank’s capital is negative and the central bank cannot successfully unwind unconventional balance sheet. Therefore, the fiscal authority and central bank should coordinate, by stabilizing the central bank’s capital, in order to isolate the perverse effects of quasi-fiscal shocks on inflation.
Of course, it’s all just theory for now.
Related links:
It’s official: Fed’s 2 per cent inflation target – FT Alphaville
A central bank is only as good as its target – FT Alphaville
The cost of global central bank balance sheet expansion – FT Alphaville
On the perils of plunging repo rates - FT Alphaville