Here's What the Fed Will Be Watching to See If Liftoff Worked

All Eyes on Yellen as Markets Await Rate Decision
  • These gauges will reveal Fed's success or failure to launch
  • Get used to saying `overnight reverse repurchase agreement'

On the eve of liftoff, the Federal Reserve must be feeling pretty good about the ability of its new tools to raise interest rates: Key money market rates are already floating obediently upward in anticipation of the U.S. central bank’s first hike in nearly a decade.

Most rates on wholesale bank deposits, repurchase agreements and commercial paper are trading above 0.25 percent, the level that will mark the bottom of the Fed’s new target range for overnight rates should Fed Chair Janet Yellen and her colleagues pull the trigger at the conclusion of their two-day policy meeting on Wednesday.

If the Federal Open Market Committee announces a quarter point increase in its overnight federal funds rate target, as is widely expected, Simon Potter, whose team at the New York Fed is charged with implementing any FOMC decision, will monitor several key market rates to judge the smoothness of liftoff. Officials’ ability to control the policy rate has been questioned because the Fed will be hiking in a market awash in excess liquidity.

First Up

First up will be the overnight London interbank offered rate fixing, posted by Intercontinental Exchange Inc. at 6:45 a.m. in New York. The rate is based on what banks think it would cost them to borrow dollar deposits in London. One-week Libor rates began rising last week in anticipation of the hike, which would take effect the day after the decision. On Monday, it was 0.3 percent, up from 0.18 percent on Dec. 9.

“The setting of Libor will be somewhat mechanical, and the market has already priced in a lot the move even before the hike,” said George Goncalves, the head of interest-rate strategy at Nomura Holdings Inc. in New York, a primary dealer. “Given this, repo rates probably will matter the most.”

Repo Rates

The New York Fed will be keenly watching rates on these repurchase agreements, known as repos, which will update on broker screens around 8 a.m., when many cash bond markets begin the trading day in New York.

In an overnight repo, borrowers take cash from counterparties and post securities as collateral, then unwind the trade the next day. The Fed uses reverse repos to temporarily drain liquidity from the financial system.

At 9:30 a.m., rates on commercial paper, which companies use to finance short-term borrowings, will be updated on traders’ screens. The Fed’s goal is to raise rates charged not just to banks, but the entire spectrum of borrowers in the U.S.

Arguably the most significant event on Thursday comes at 1:15 p.m., when the New York Fed announces the results of its first overnight reverse repo operation after the rate hike. The Fed has been testing the overnight reverse repo facility, a key part of its toolkit, for more than two years, mostly at a 0.05 percent rate.

The program, which allows the Fed to tie up the nearly $3 trillion of excess cash created from its post-crisis bond purchases, is expected to offer a 0.25 percent rate on overnight borrowings after the hike. This is to form the bottom of the Fed’s new target range.

Big Test

The big question for the Fed is how much money investors will offer to lend to it at this rate, and whether it’s more than the limit set by the central bank. If investors offer to lend the Fed more money than the Fed is willing to borrow, the central bank won’t be able to keep interest rates in its new target range.

It’s been testing the facility with a cap on transactions of $300 billion per day. Over the last two years, in testing, the Fed has borrowed $114 billion each day on average. The cap was breached on Sept. 30, 2014 due to outsize demand for liquidity on the last day of the quarter. Investors offered to lend the Fed $407.2 billion at rates as low as minus 0.2 percent.

The 22 primary dealers that trade directly with the Fed expect the FOMC to announce Wednesday alongside its policy statement that the cap will be raised to $500 billion, while daily borrowings immediately after liftoff are expected to rise to $300 billion, according to a New York Fed survey ahead of the October FOMC meeting. The minutes of the June meeting said participants agreed that the cap should be increased or suspended at liftoff.

The rest of the nearly $3 trillion of cash the Fed created to buy bonds that isn’t lent back to it through reverse repos is deposited in accounts at banks, which take the money and keep it on deposit at the central bank in the form of excess reserves. The Fed pays banks 0.25 percent interest on excess reserves, and will move that rate to 0.5 percent after the hike. This will form the top of its new target range.

Unwelcome Burden

Banks for the most part don’t like to hold this money for investors, because it takes up a lot of space on their balance sheets and the returns are low. JPMorgan Chase & Co., the largest U.S. bank by assets, has even begun charging investors to place cash on deposit.

When the Fed raises rates from near zero, where they’ve been since 2008, money-market mutual funds will probably be able to attract more of this investor cash by offering higher interest rates and then lending the money to the Fed via the overnight reverse repo facility.

That probably won’t happen on day one, however, because it could take some time for investors to move their cash from banks to money-market funds, said Joseph Abate, a money-market strategist at Barclays Plc in New York, a primary dealer.

Still, the risk is that if the hike causes market turmoil and investors offer to lend the Fed more money than the limit, driving the rate below the posted 0.25 percent, that “could add to uncertainty as people may get nervous if the Fed can actually get rates to go where they want to,” added Goncalves.

The finale will come Friday morning at about 8:00 a.m. New York time, when the first post-liftoff federal funds effective rate print is published. The effective rate is based on trades the previous day and is the main rate the Fed targets.

If the reverse repo operation on Thursday afternoon isn’t oversubscribed, the fed funds rate should trade above the 0.25 percent floor established by the rate the Fed offers to borrow at through reverse repos and officials can declare a successful start to liftoff.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE