Navigating the Mechanics of the Fed's Rate Rise Could Prove More Turbulent Than Expected

Buckle up.

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Short-term rates up? Check? Repo usage uncapped? Check.

Source: Bloomberg

Investors preparing for interest rate liftoff are in the proverbial pilot seat and doing their preflight checklist.

So far everything looks pretty good, with movement in short-term rates—the equivalent of turning on a plane's auxiliary power unit—ticking up nicely following the announcement of the first interest rate hike by the Federal Reserve in almost a decade. Takeoff is well and truly a go.

Zoltan Pozsar and James Sweeney, shadow banking experts and Credit Suisse analysts, remind us, however, that markets need to consider a long list of mechanical factors that go beyond the basic preflight checklist. The exact mechanism through which the Fed is raising short-term rates and reversing years of easy monetary policy following the 2008 crisis is something known as overnight reverse repos, or RRPs, for short. These RRPs will see the Fed drain liquidity by dealing with money market funds and broker-dealers, who will lend the central bank money in exchange for U.S. Treasuries (and a "repo" agreement to buy them back). But use of the RRP facility is occurring in a much-changed financial system that has seen the role of banks in the repo market diminished and their balance sheets transformed.

In other words, two grand experiments—one conducted in the backwaters of monetary policy and the other through regulatory change of the financial system—have combined to make liftoff far more complicated. If investors were once piloting a rate hike with a Boeing 737-200, they are now navigating with an Airbus A380, full of new functionality, a much larger size (and continued rumors of mechanical fatigue).

Or, as Pozsar and Sweeney put it in their note: "Take-off may go fine but volatile weather systems at 30,000 feet are another matter. Does the average portfolio manager know what it is like up there, or will he or she be trading blind?"

The big issue here is the degree to which money market funds make use of the Fed's RRP facility to lure big depositors in search of higher returns away from interest-bearing accounts at banks, which have seen big amounts of cash parked on their balance sheets in the aftermath of the financial crisis and years of low interest rates. As the central bank raises rates, the difference between rates paid by bank accounts and money market funds is expected to rise, encouraging a bunch of depositors to move money from banks to newly higher-interest accounts. 

Money market funds, bouyed by new access to the Fed, "are getting ready to bid away hundreds of billions in nonoperating deposits from banks and invest those funds in reverse repos at the Fed," say Pozsar and Sweeney. "The more generous these funds are in passing on the first hike, the more deposits they will lure away from banks and the greater the usage of the RRP facility."

When it comes to just how much deposits money market funds could attract from banks, however, there is an ongoing debate. Pozsar and Sweeney predict a looming price war. As in the oil market, they argue, the biggest such funds will have incentives to lower fees in an effort to hurt their competitors (much like Saudi Arabia depressing oil prices to keep market share) while smaller funds will raise their commissions.

The probable shift of money from banks to money market funds poses extra complications for some of the world's biggest financial institutions, which are now required to hold big buffers of high-quality liquid assets (or HQLA) to cover potential outflows of a particular brand of flighty or wholesale deposits (known as nonoperating deposits under Basel III banking regulation definitions). 

In fact, by Pozsar and Sweeney's estimates, some $600 billion worth of nonoperating deposits currently held at the largest banks could shift to money market funds within a year. (On the plus side, some retail deposits are expected to move from money market funds and into banks).

Source: Credit Suisse

With a large portion of nonoperating deposits forecast to migrate from banks to money market funds, the former institutions will need to adjust their balance sheets to deal with the outflows. Since many have been building their HQLA holdings in tandem with the cash inflows of recent post-crisis years, outflows of nonoperating deposits could see that trend reverse. "The loss of buyside non-operating deposits would now leave the bank with an HQLA surplus ... giving the bank a welcome degree of balance sheet flexibility it lacks at present: whether to sell HQLA and buy credit or, alternatively, to push down rates on some corporate nonoperating deposits to force them to leave (losing some of the excess HQLA in the process) is up to bank [chief investment officers] and treasurers to decide," as Pozsar and Sweeney put it.

Such decisions may seem like esoteric points, but in a world where the consensus trade for 2016 is still a flattening of the U.S Treasury curve, the idea of banks potentially selling government bonds could throw a gremlin or two into portfolio managers' planned flight paths.

In other words, investors would do well to earn their liftoff pilot's license as soon as possible.

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