Credit Suisse: The Fed Needs to Talk About How Foreign Banks Are Helping It Raise Rates
What drains liquidity, has never been mentioned by a Federal Reserve official, and is growing fast?
The U.S. central bank's foreign overnight reverse repurchase agreements (RRPs), of course!
While much of the focus has been on the RRPs the Fed is undertaking with U.S. banks and money market funds in order to reverse years of easy monetary policy and raise benchmark interest rates, less attention has been paid to a similar program offered to foreign central banks. A new paper by Zoltan Pozsar, analyst at Credit Suisse Group AG, sheds light on the extent to which foreign central banks have been tapping the facility, largely at the expense of money funds.
"Many clients have asked the Fed about the foreign RRP facility, and the response they got was that it is just a service offering for foreign banks. But in our view it is more than just a 'service offering," writes Pozsar, meaning that the facility has become a key cog in the central bank's rate-raising machinery.
Indeed, at a time when domestic take-up of the RRP has been far less than expected—at about $80 billion and falling—the foreign RRP facility currently stands at $220 billion and is fast increasing.
The foreign RRP program primarily sees foreign central banks trade out of short-term U.S. Treasury bills in exchange for cash, effectively draining excess liquidity from the system and with the bonus result of freeing up T-bills for other investors.
Since the start of last year, foreign central banks have traded out of $120 billion of bills, Pozsar notes, and invested in an equivalent amount in the foreign RRP facility in two waves: $60 billion in the first half of 2015 and another $60 billion in the third quarter.
Since the Fed's rate hike in December, however, the intensity of the sales appears to have accelerated, though the deals have a natural cap of another $300 billion—or the amount of T-bills currently held by foreign banks, according to U.S. Treasury Department data.
Using the foreign RRP program allows the central bank to push yields on T-bills upward while encouraging big investors to move out of cash and into the bill market, thereby lifting rates. It is literally pulling rates up by their T-bill bootstraps, though much of the program remains a mystery.
"The pricing of the foreign RRP facility is a key piece of the puzzle," says Pozsar. While the Fed publishes the rate it pays on overnight borrowings through RRPs with both domestic money funds and primary dealer banks daily, the rate on the foreign RRP facility "takes a bit of detective work to find," he notes.
Deep in the Fed's unaudited quarterly financial statements is where the published rate lies—thought not, intriguingly, in the central bank's audited annual statements.
A glance at the below Credit Suisse chart, showing rates paid for domestic RRPs (the thick blue line and the thin orange line) and foreign RRPs (the thick red line), reveals some interesting trends. A regime shift occurred in 2015, with the foreign rate eclipsing both domestic rates, but that conceals a wide dispersion of rates paid for different bills, as shown in the second chart.
"The New York Fed appears to be pricing the foreign RRP opportunistically," says Pozsar, thereby encouraging foreign central banks to offload certain holdings of T-bills at certain times. Indeed, rates paid for T-bills with one- and three-month durations have been substantially higher than the equivalent securities' yields to encourage such a shift.
As noted by Matt Boesler of Bloomberg News, expansion of the foreign RRP pool could also be a sign that large U.S. banks are telling foreign central banks to take their excess dollars elsewhere. Indeed, Pozsar notes in his paper that the deposit outflows widely expected to come out of U.S. banks as a result of the RRPs have materialized faster than forecast and in the face of the smaller-than-expected take-up of the domestic facility.
Back to the foreign RRP program itself, channeling Ricky Ricardo, Pozsar writes that: "Despite this very successful experiment, the New York Fed has some explaining to do. First for a facility that appears to be more meaningful than the overnight RRP facility—both in terms of the amount of reserves it helped drain and the impact it has on short-term rates—it is a touch odd to us that the foreign RRP facility has never been mentioned in FOMC minutes before. That flies in the face of central bank transparency."
"Second, given that the foreign RRP rate has such a great influence on bill yields and is an effective tool to manage the supply of bills available for cash pools, its pricing should be more transparent and available at a higher frequency. Discuss."
Indeed, the machinations of foreign central banks when it comes to their portfolios of T-bills is no small matter and stands in stark contrast to previous expectations that the domestic RRPs would prove a huge boon to money market funds, which would enjoy an influx of investors searching for higher rates of return with the added bonus of reserve accounts held at the Fed. Instead, thanks to a freed-up supply of T-bills, buy-side investors now have the option of investing in money funds or running their bill portfolios themselves.
"Based on our conversations with buy-side investors (those who were already incentivized out of non-operating deposits by their banks or who are presently considering where to move), an overwhelming majority prefer the ability to run a bill portfolio directly, on their own," says Pozsar. "In the end, the Fed's long-standing aversion to money funds—whether prime or government-only—seems to have dominated the FOMC's thinking.
Rather than boosting money funds' collective fortunes, policy innovations have reduced what role the funds might have played as middlemen, as investors "did end up getting their Treasury bill 'fix.' "
Of course, with a cap on the foreign RRP facility of some $300 billion more, money market funds' luck could yet turn around.
Concludes Pozsar: "To be sure the sun still rises in the morning and the Earth still revolves on its axis under this alternative configuration, but as always some groups win (cash pools through more bills, higher yields), and some groups lose (money funds through foregone assets under management and fees)."