Money market pros have had time to take in and process the latest actions from the Federal Reserve and have detected an attitude adjustment by the Fed with respect to interest rates and the reverse repo program. Specifically, Federated's Debbie Cunningham, chief investment officer, global money markets, suggests a possible shift in the Fed's thinking on interest rates in latest "Month in Cash" column, "Fed Shifting to the Other Side of Average." Writes Cunningham, "While reflecting on the recently released minutes of the July Federal Open Market Committee (FOMC), I felt one good way to explain the Federal Reserve's slight shift in policy language is to imagine a line that represents the average of the members' opinions on when the federal funds rate will raise and to what level. This year to date, the majority of the officials have fallen below the mean, so the Fed has tended to be the "dovish" side of the average, in need of continued accommodative policy to reach target employment and inflation levels. This is why the Fed is likely to further draw out the inordinate amount of time rates are extremely low. Lately, however, more policymakers have crossed over that magic line, pushing the Fed to watch out for overstimulation instead in light of an improving economy."

She explains, "It is such a subtle shift, but has a huge impact. Chair Janet Yellen's keynote address at the recent Jackson Hole symposium encapsulated this. She was much less dovish than she has been in past speeches and I think that has to be indicative of a growing debate and discussion within the FOMC of the risk of overshooting targets. The minutes of the last FOMC meeting stated, "Indeed some participants viewed the actual and expected progress toward the committee's goals as sufficient to call for a relatively prompt move toward reducing policy accommodation...." In Fed-speak, "some" is generally thought to be as many as five, which is a pretty big number of members."

Adds Cunningham, "We continue to assert that the Fed will not raise the benchmark rate until probably second quarter of 2015. For some time, the consensus prediction for a rise was firmly at the end of the second quarter. It is now trending toward May and April, a response to that shift across the mean. For the most part, our Prime portfolios are on the short end of the weighted average maturity (WAM) range, while their weighted average lives (WAL) on the long end. That's due to our desire to own floating-rate securities and sell longer-dated, fixed-rate paper. The implication is that, later in the year, we will start to see a slight rise in yields in the 1- to 3-month sector. We think that will be a good balance for the portfolio to keep in line with market rates."

Wells Fargo's Dave Sylvester, head of money funds, and his team published a column on the Fed's reverse repo program. "In the minutes of the July 30–31, 2013, meeting of the Federal Open Market Committee (FOMC) released in August 2013, we learned the FOMC had been briefed "on the potential for establishing a fixed-rate, full allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates.... The purpose of this new overnight reverse repurchase agreement facility (ON RRP) would be to place a floor under interest rates to improve the effectiveness of the monetary policy implementation when the FOMC chooses to raise short-term rates."

Continues Sylvester, "In addition to achieving its monetary policy goal of placing a floor under rates, ON RRP has also given money market funds some much needed supply, considering other sources of liquid investments, such as bank deposits and Treasury bills, continue to contract.... Some money market fund managers have hailed ON RRP as the solution to the supply woes that have plagued the money markets for the past half-decade or more, but it now appears the Fed may not be quite as enthusiastic about ON RRP as these money market funds."

He says, "The minutes from the FOMC's June 17-18 meeting revealed that some members had concerns about "potential unintended consequences" of the ON RRP facility. Writes Sylvester, "According to the minutes, "most participants expressed concern that in times of financial stress, the facility's counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress." In other words, by providing an indirect alternative to bank deposits that was unlimited in size (full allotment), ON RRP could exacerbate a bank run."

The Wells piece explains, "Further, "... a number of participants noted a relatively large ON RRP facility had the potential to expand the Federal Reserve's role in financial intermediation and reshape the financial industry in ways that were difficult to anticipate." The minutes also revealed that, "a number of participants expressed concern about conducting monetary policy operations with nontraditional counterparties." We also learned that where many money market participants saw the rate on ON RRP being set at or near IOER, the FOMC saw a wider spread, "... perhaps near or above the current level of 20 basis points [bps; 100 bps equals 1.00%]..." would be more effective."

Sylvester continues, "As market participants were digesting this rejection by their new BFF, the minutes of the July 29–30, 2014, FOMC meeting revealed an even more diminished role for ON RRP. The committee reaffirmed the role of the "... federal funds rate as the key policy rate ..." and its support of "... a target range of 25 bps for this rate at the time of liftoff and for some time thereafter." ON RRP was pushed further back in line as "participants agreed that adjustments in the IOER rate would be the primary tool used to move the federal funds rate ... and influence other money market rates." Gone was the promise of a permanent new source of unlimited supply implied by the term full allotment used in the initial discussion of ON RRP a year ago. As tests revealed that the facility has been effective in establishing a floor under rates even with a limit on the allocation to each counterparty, the FOMC was comfortable now saying, "... the ON RRP facility should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose.""

Why the change in attitude toward RRP? "We think there are several answers to that question. For one thing, the change is probably not all that sudden and the discussion stems from an evaluation by the FOMC of the results of its now year-long test of ON RRP. It would probably be more disturbing if, after a year of tests, it made no changes to the original layout of the facility. One of the downsides to a more transparent process at the Fed is there can be a lot of cross talk. For those of us used to speaking in one corporate voice, this can sometimes be confusing. We must also recognize this is a sea change in the mechanics of monetary policy and the Fed is a fundamentally conservative organization that may not handle radical change all that well. That the necessity of such a dramatic change stems from the explosion in its own balance sheet, of its own doing, probably doesn’t alter that basic feature of the Fed."

He continues, "The idea of ON RRP as a potential facilitator of a bank run probably looms larger in the minds of the FOMC members than in those of money market participants. Low probability, high negative outcome events are of utmost interest to the Fed, and because unlimited size does not appear to be necessary in order to establish a floor under money market rates, there is no need to even open the possibility -- better to limit the size now than to scramble to find the right formula and do so in the midst of a crisis. The idea that the Fed is uncomfortable with taking on a role as financial intermediary should not be discounted. These are, after all, the same folks who sponsored the transparently titled "Workshop on the Risks of Wholesale Funding" at the New York Fed this past month, and several Fed presidents have consistently been outspoken critics of money market funds during the recent debate on regulatory change. So the idea of actually transacting with money market funds and becoming an integral part of the woefully misnamed shadow banking system is likely an anathema to some of the FOMC members."

So where does this leave us, asks Sylvester? "If the Fed is still interested in placing a reasonably firm floor under money market rates -- and every indication is that it is -- then we will likely see a continuation of the ON RRP facility beyond the end of the test period. Regulatory changes mandating holdings of high-quality liquid assets by banks, money market funds, derivative markets participants, and others, along with a continued strong investor preference for liquidity, point to a strong demand for overnight investments. Prior to the test of the ON RRP, we did see repo rates dip into negative territory on occasion, so it would appear that ON RRP fixes that particular problem.... So, we are put on notice that the Fed is adopting ON RRP with reservations and will not keep the program in place a moment longer than is absolutely necessary. But we are not as optimistic as the Fed about its ability to shrink its balance sheet, which now stands at an astounding $4.5 trillion and consists mostly of U.S. Treasury, agency, and mortgage-backed securities acquired in the implementation of its quantitative easing programs. So we would expect, absent a better idea, ON RRP will be a feature through this entire next cycle of tightening of monetary policy and up to the next time the Fed chooses to ease -- or, in money market lives, well over a thousand overnight maturity rolls. Who knows? By the time it's all over we may all become BFFs yet!"

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