Fed Repo Program Use Surges as Exit Plan Speculation Rises

Use of the Federal Reserve’s reverse repurchase agreement facility is surging as speculation rises that policy makers may make the program a permanent tool to be used during the unwinding of unprecedented monetary stimulus.

Daily usage has averaged $194 billion a day in May, compared with $86 billion in the first three months of the year and $11.8 billion on Sept. 23, the day the Fed began testing the fixed-rate facility. Minutes released today of the Fed’s April 30 meeting showed policy makers heard a staff presentation on how to control short-term interest rates that included the overnight repo agreements.

The program lets banks, broker-dealers, money-market funds and some government-sponsored enterprises lend the Fed cash overnight at a fixed rate, currently 0.05 percent, in exchange for borrowing Treasuries in so-called reverse repo transactions. In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.

“It’s not necessarily a bad thing that the Fed’s presence in money markets has increased,” Brian Smedley, an interest-rate strategist at Bank of America Corp. in New York, said in a telephone interview on May 19. “The Fed has always been the dominant factor in determining the general level of overnight rates; in the pre-crisis era they were managing the Fed effective rate through their open market operations.”

Daily Allotment

The program has helped put a floor under money-market rates, which may otherwise have slide toward zero given a seasonal shortage of bills and heightened safe-haven demand, according to Barclays Plc. The allure of the facility has risen as investors face limited Treasury bills supply and regulatory pressures increasing the need for the safest of debt.

The per-counterparty daily allotment cap is currently set at $10 billion, up from $500 million when the program began in September. At full capacity, these limits would be removed, according to minutes from the July 2013 meeting of the Fed.

The facility “allows us to make a short-term safe asset more widely available to a broad range of financial market participants,” New York Fed President William Dudley said yesterday in remarks before New York Association for Business Economics.

Federal Bank of San Francisco President John Williams told reporters on May 19 following a panel discussion in Dallas that the overnight fixed-rate reverse repurchase program “should be part of our toolkit” as the Fed begins raising interest rates.

The Federal Open Market Committee, which is buying bonds to hold down long-term interest rates and spur growth, last month announced plans to cut monthly asset purchases by $10 billion, to $45 billion.

Exit Strategy

“We believe it is too early to expect updates on the Fed’s exit strategy and on how it will approach normalizing policy,” wrote David Keeble, the New York-based head of fixed-income strategy at Credit Agricole SA, in note published on May 16. “However, we expect it to be revised eventually to take into account the role of the reverse repo facility.”

Prior to the financial crisis, the Fed would add or drain reserves from the banking system through its temporary open market operations as means to guide its target rate up or down. The Fed sought to keep its effective rate, a volume-weighted average on trades in overnight funds, in line with their target.

Supply of high-quality, short-term debt, is falling at the same time as a heightened regulatory environment boosts the need for the debt. The Treasury has cut sales of short-term debt as it pushed to lock in record low rates over the longer term. Treasury data shows bills now account for just 12.1 percentage of total marketable debt, is the lowest since 1953, according to Barclays.

Daily Financing

The Fed’s agreements have also gained in allure as yields on alternative debt has fall in line with the fixed reverse repo rate and as dealers pull back from the repo market as they shore up balance sheet. The general collateral finance repo rate for Treasuries averaged 0.056 percent yesterday, according to the DTCC GCF Treasury Repo index.

The amount of daily securities financed in the tri-party repo market was $1.52 trillion as of April 9, Fed data show. That’s down from a peak of more than $2.8 trillion a day on average in 2008.

Some market participants, as well as the Fed’s Dudley, do see potential risk of the reverse repo program, including the growing ’’footprint’’ the central bank has in the money market, according to the New York Fed president.

Program Risks

If the facility grew excessively and had a rate close to that the central bank offers on excess reserves, now 0.25 percent, it “might result in a large amount of dis-intermediation out of banks through money market funds and other financial intermediaries into the facility.”

Deborah Cunningham, the head of money-market funds at Pittsburgh-based Federated Investors Inc., the fourth-largest U.S. money fund manager, said they are still maintaining relationships with a wide array of repo counterparties given these risks.

“You’ve already have banks and other players exiting the traditional repo marketplace,” Cunningham said in a telephone interview yesterday. “Two years from now, when the Fed’s balance sheet is only half the size and they decide the program is not as an important feature as it used to be, does that leave most of us that are still reliant on the liquidity in the overnight traditional repo marketplace without a provider or with a lack of diversification?”

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