While the Federal Reserve is expected to raise interest rates next week to great fanfare or consternation, depending on your particular view, it’s what happens next that could determine whether the market yawns or shrieks.
The central bank can’t just flip a switch and suddenly lift benchmark borrowing costs. It has lost considerable control over rates in the $13 trillion U.S. government bond market after seven years of unconventional monetary policies. This is bound to be a complicated process, one that includes substantial experimentation by central bankers.
It is this mechanical question, and not just the more widely discussed macroeconomic implications, that could stir up volatility in coming weeks. Markets hate uncertainty, and there’s going to be a ton of it even after the Fed announces liftoff.
At the heart of this uneasiness is the fact that banks don’t really need temporary money from the Fed. After all, they have so much cash sloshing around already that they don’t know what to do with it. Why would they want to borrow more money at an even higher rate?
Instead, the Fed needs to drain cash from the system. Its main obstacle may be the Federal Home Loan Banks, which now dominate a fed funds market that’s shrunk to about one-fifth the size it was before the financial crisis. The Fed wants these banks to start parking their cash in a reverse repurchase facility, thus removing some money that otherwise would flood the fed funds market and suppress borrowing costs.
Some hurdles loom, however, as described by Barclays analysts led by Joseph Abate: Even if they’re promised higher interest rates in a repurchase facility, the home loan banks may still prefer to keep their money in the fed funds market because it gives them greater flexibility when they want it back. Repurchase facilities are more restrictive about the timing of withdrawals.
If the home loan banks are uncooperative, the Fed could turn to its “nuclear option,” as the Barclays analysts put it, and sell some of its trillions of dollars of assets. That would spread chaos among government-debt traders, with yields on debt of various maturities rising. The Fed’s balance sheet has more than quadrupled since 2008, to more than $4 trillion; it has a lot to sell should it choose to.
This possibility is “very, very remote,” Abate said in a report by Bloomberg’s Alexandra Harris. But it’s worth considering if only to underscore how difficult it may be for the Fed to raise rates for the first time in almost a decade. While the move is small, a mere 0.25 percentage point, its implementation will test the flexibility of a market that’s transformed since the credit crisis.
For now, many traders are just hiding out, worrying about how this liftoff will be carried out, as Bloomberg’s Liz Capo McCormick and Alexandra Scaggs reported Thursday.
Volatility awaits, that’s for sure, but there may be an upside. Market dynamics have been somewhat shrouded in years of easy-money policies, and the Fed’s action will help illuminate the landscape. The pain will be akin to ripping the Band-Aid off fast or peeling it off slow, depending on how the Fed manages the plumbing.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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