Fed Surprise Has Strategists Pondering June IOER Tweak: Roundup

  • Deutsche Bank expects IOER change with next Fed rate hike
  • “Essentially, the Fed delivered a 5bp cut”: Bank of America

Federal Reserve policy makers have been talking about whether it might be appropriate to boost one of the central bank’s key rates by less than the others to keep the effective fed funds rate firmly within its target range.

Such a change may come as soon as June, according to Wall Street strategists, and while there could be downward pressure on other money market rates, market expectations for how quickly the Fed might tighten policy haven’t shifted much.

The unexpected revelation of this discussion in minutes of the central bank’s latest meeting sparked a surge in fed funds futures volumes on Wednesday as traders scrambled to take into account a potential change to interest on excess reserves, or IOER, the rate it pays to banks for surplus cash kept at the Fed.

The discussion by the Federal Open Market Committee came about following the recent narrowing of the spread between the effective fed funds rate -- which lies within the central bank’s target range -- and the IOER, which is currently in line with upper bound of that range. The idea of having the IOER five basis points below the top of the main target range is that even if the effective rate were to match or slightly eclipse the IOER, it could remain within that official range. The effective rate is presently around five basis points shy of IOER.

What the Strategists Say

  • NatWest (Blake Gwinn)
    • While fed funds trading a few basis points above IOER may not be “that meaningful,” there’s a “legitimate optic/credibility concern” with missing a target range that’s 25 basis points wide
    • By lowering the IOER rate, the Fed’s markets desk would be creating an extra 5-basis-point buffer for a “potential ‘miss’ in which the effective printed outside the range”
    • MORE
  • Bank of America (Mark Cabana)
    • “Essentially, the Fed delivered a 5bp cut” via the FOMC minutes compared with market expectations, which should put similar downward pressure on other money market rates such as repurchase agreements, short-term Treasuries, agency discount notes and commercial paper
    • “Over time the impact of this adjustment should decline given our view that that repo continues to move higher with elevated Treasury supply and fed funds trades above IOER”
    • MORE
  • Deutsche Bank (Steven Zeng)
    • The Fed’s potential tweak to its IOER rate is about “protecting and maintaining full control of its single most important interest rate” and adjusting IOER “likely represents the simplest one to communicate and to implement”
    • Deutsche Bank expects IOER adjustment at same time as next rate hike, which is likely June; sees no benefit to waiting because it could only introduce uncertainty into OIS and create unwanted short-end volatility
    • By changing IOER, the Fed forces close substitutes of fed funds, “namely overnight Treasury repo,” to reprice accordingly
    • MORE
  • Wrightson ICAP (Lou Crandall)
    • The Fed “really has no choice but to follow through with an undersized rate hike” in June as the pricing uncertainty associated with the possibility “will hang over the market”
    • Useful for the Fed to establish precedent that the administered rates don’t need to coincide with the upper and lower limits of its formal target range, as it will give the central bank more flexibility over time
    • The gradual convergence of the fed funds rate with the upper limit of the target range wasn’t “a problem in need of a solution”
    • MORE
  • Morgan Stanley (Matthew Hornbach, Sam Elprince)
    • By reducing IOER further in the future, Fed can delay when the effective rate exceeds the upper bound of the range, which would allow balance-sheet normalization to continue beyond 2020
    • Future technical adjustments to IOER may put relative steepening pressure on yield curve, though it’s unlikely that will overcome the flattening pressure coming from the remaining Fed rate hikes in this cycle
    • MORE
  • Jefferies (Ward McCarthy, Thomas Simons)
    • The “current state of affairs” doesn’t justify a “significant change in operating procedure, but the Committee is being prudent by having this discussion ahead of time”
    • If fed funds is only 2-3bp below IOER by early June, it’s possible that the Fed would implement this policy at the June meeting
    • “It might make more sense for the Fed to investigate the issues a little bit more and communicate these issues to the market before making a change”
  • BMO (Ian Lyngen, Aaron Kohli)
    • If the Fed’s goal is to keep fed funds rate in the middle of a formal target range, “taking a bit off the top of IOER seems as good of a way as any to accomplish this”
    • Path that the market expects for the fed funds rate likely lower today and whether that filters into broader front-end funding markets like repo remain “the open question for now”

— With assistance by Stephen Spratt

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