Wednesday, May 7, 2014

Fed Cornered by QE Program – Reverse Repo Path Being Considered

In Fed Chair Janet Yellen’s testimony to the Senate Banking committee on May 7, 2014 there were many questions about when the Fed would “normalize” its interest rate policy, specifically the Fed Funds rate.  She stuck to the party line, saying it is expected to be a “considerable time” before the Fed will raise short term interest rates.  When pressed for a definition of “considerable”, she did a political dance and left the definition to “it depends on economic circumstances”.  In other words, it depends on what will do the least amount of damage to the political party in charge.

One path to actually raise interest rates, but escape the consequences that raising the Fed Funds rate entails, is to use a technique known as the Reverse Repo.  The "experiment" that the Fed is currently actively
discussing is a possible means of managing the large amount of "excess" reserves they have pumped into the U.S. financial system. Here is an excerpt from a WSJ article, Fed Debate on Exit Strategy Isn't Over, which explains what may happen in the near future:

"The Fed is experimenting with another rate called a reverse repo rate. This rate appeals to officials because they can move it around without worrying about the level of reserves in the banking system. But switching to it wouldn’t be simple. Abandoning the fed funds rate could cause huge headaches because so many financial contracts are tied to it. Traditionally, the Fed has moved the fed funds rate up or down to tighten or loosen credit in the banking system. But the fed funds rate could be difficult to manage in the future. The rate is driven up or down by the level of reserves in the banking system.  The Fed QE program has flooded the banking system with reserves since 2008, loosening its grip on the rate."

In a nutshell, the Federal Reserve is looking for a way to pay-off the banks to finance its balance sheet which is composed of U.S. Treasury debt (a high percentage long duration debt with an average 5% coupon) and Mortgage Backed Securities (also high coupon), rather than the alternative in which the banks lend out the $2T plus excess reserves that have been built up in the banking system or given back to the Fed in the case where the Fed Funds rate is increased.  Raising the Fed Funds rate would force the Fed to have to sell Treasuries from its balance sheet, putting pressure up on the Treasury curve that the majority of investors are currently expecting, but also increasing the supply of Treasuries or MBS for sale in the market.  Under the reverse repo scheme, rates are changed and the banks make more money, but the Fed is able to maintain the size of its balance sheet.  Magic?

The big deal here is that essentially a large segment of the capital market which is quarantined now with the Fed QE program, may well continue to be manipulated indefinitely into the future.  Actual capital flows in the form of lending for real economic expansion, (i.e. capital expenditures) is likely to continue to be constrained, controlled by a small committee of government officials. 

In my opinion, the Fed is in a corner which is caused by the financing needs of the U.S. Treasury for the National Debt which is greater than 100% of GDP.  Rather than moving toward free market solutions they are using a playbook which will lock the economy into a slow growth and eventually inflationary spiral due to the continuing lack of private capital investment.

If you want to learn more about how the U.S. financial system works and the impact that Federal Reserve and government fiscal policy have historically had on the investment markets, please pick up a copy of the book, Theory of Financial Relativity –Unlocking Market Mysteries that will Make You a Better Investor.

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