• Overseas central banks biggest players in reverse repo market
  • Strong foreign demand making it easier to hold Fed rate floor

The Federal Reserve’s efforts to ensure its interest rate increase filters through to the broader U.S. economy have found an unexpected counterparty: foreign central banks.

The Fed borrows billions of dollars daily to put a floor under its benchmark policy rate and this business has become dominated by overseas monetary authorities, instead of the U.S.-based money-market mutual funds who had been expected to be the biggest players.

The trend, which might have been encouraged by volatility in foreign exchange markets, is making it easier for the Fed to maintain its new target range for the federal funds rate following its decision last month to raise rates after seven years near zero.

Excess Reserves

The transactions, known as overnight reverse repurchase agreements, or RRPs, allow the Fed to borrow cash overnight and post securities from its bond portfolio as collateral, unwinding the trade the next day. They are a way to tie up some of the nearly $3 trillion of excess reserves in the banking system created by the Fed’s post-crisis bond purchase programs, which weigh on short-term borrowing costs unless they are drained.

Dealers surveyed before the Fed’s Dec. 16 rate hike announcement showed the median respondent expected the U.S. central bank would need to borrow $300 billion from money-market funds on a daily basis through RRPs to keep rates in the new 0.25-0.5 percent target range.

Instead, daily borrowings from those funds through overnight RRPs has averaged only around $153 billion since rate liftoff. But borrowing by foreign central banks, many of whom maintain large portfolios of U.S.-dollar denominated assets, ballooned to $216 billion on Jan. 20, more than double the amount borrowed a year ago, according to the latest data published by the Fed.

Different Direction

"The idea of the domestic RRP facility is to build more of a floor under market rates and this is an opportunity to extend that in a different direction," said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

The New York Fed raised the rate it pays on overnight borrowings through RRPs with foreign central banks to 0.09 percent on average over the first nine months of 2015 from 0.03 percent during the same period of 2014, according to the U.S. central bank’s latest quarterly financial statements. During the same period the Federal Open Market Committee held the RRP rate paid to domestic money-market funds at 0.05 percent.

Crandall, a former Fed economist, said foreign central bank reserve managers are probably utilizing Fed RRPs as a liquidity cushion, because they are easier to liquidate than U.S. government debt holdings at short notice.

Forex Turbulence

"In the 1990s, it wasn’t uncommon to see the RRP pool pop during periods of foreign exchange turbulence for precisely that reason: that funds would be positioned there, ready for use," he said.

U.S. Treasury and agency securities held in custody accounts at the New York Fed for foreign central banks have declined $113 billion since July, while RRPs with foreign central banks have increased $60 billion over the same period.

Expansion of the foreign RRP pool could also be a sign that big domestic banks are telling foreign central banks to take their excess dollars elsewhere, because U.S. banks are trying to shrink their balance sheets, said Joseph Abate, a money-market strategist at Barclays Plc in New York, one of the 22 primary dealers that trades directly with the Fed.

"Balance sheet scarcity at the large banks is causing the banks themselves to rethink some of their operations," Abate said. Holding dollar deposits for foreign central banks "is one example of a business that may consume more balance sheet than the returns justify."

Regardless of whether RRPs are replacing bank deposits or Treasury and agency securities in foreign central banks’ reserve portfolios, they relieve downward pressure on U.S. money-market rates, Crandall said. In the former case, fewer deposits free up bank balance sheet space and reduce excess reserves that would weigh on market rates. In the latter case, an increased supply of securities circulating in money markets eases downward pressure on rates as well.

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