Rates Spark: The Fed Wouldn’t Dare, Would They?

No rate or QE change likely from the Fed - that's the easy bit. But, will they hike the rate on excess reserves? Not expected (but they actually should). Will they extend the SLR break for US banks? They likely will (but probably shouldn't). Will the dot plot move? Likely not much. Will the terminal rate rise? Likely not. But then again, they might not not ...

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With the broad brush of Fed policy in a holding pattern for the fed funds rate and the volumes of QE being done, the Fed might just get a bit more technical than usual this time around. Two key items here.

First, they may well have something to say on the emergency adjustment made to the supplementary leverage ratio when COVID broke about a year ago. Back then, the Fed decided to allow US banks to exclude holdings of Treasuries and deposits at the Fed from it, but for a temporary period that is due to end on 31 March 2021. We think they will extend it, and if so, there is nothing to see here. But, if the Fed were to choose not to extend, then there could be repercussions. One could be selling of US bank holdings of Treasuries; we calculate that they currently hold an excess of some $600bn. Another could be that banks choose to take fewer deposits. We think this is less likely, despite the tough talk in some quarters, but the Fed could choose to avert this discussion by just extending for deposits, and not for Treasuries. To be seen.

Second, the Fed will be aware that the Secured Overnight Financing Rate (SOFR) has been peppering the 1bp to 2bp area in recent weeks. The SOFR rate is not a Fed policy rate, but still, if it were to hit zero (or worse, dip negative, even if unlikely with the Fed there with a zero repo rate) it would be a tad inconvenient. It could suggest that the Fed has lost some control over the front end, as a key rate hits zero while the economy kicks through the gears. But also, SOFR is an important rate to say the least, as it is the favored rate for use on transition from Libor. In fact, there is official sector pressure in place on players to make that switch sooner rather than later. If SOFR were to go negative, even if briefly, it could cause some to pause for thought. What to do? Provision of more collateral through issuance is one solution. Another is to hike the rate on excess reserves (IOER), just to act as a pull upward on other front end homes for liquidity.

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