While Co-Head of Global Bonds Nick Maroutsos agrees with the US Federal Reserve (Fed) holding benchmark rates steady, he is concerned that the risk to short-term lending markets will remain elevated until the central bank addresses issues in the market’s post-crisis infrastructure.
- When measured against its dual mandate of balancing inflation and employment, the Fed’s decision to hold rates steady was the correct call.
- With market stability having become a de facto third pillar of the Fed’s mandate, the central bank is doing itself a disservice by ignoring the flaws in the current infrastructure of short-term lending markets.
- We believe the Fed should be proactive in taking steps to improve repo market functioning by lowering bank reserve requirements, incentive lending excess reserves and commit to additional asset purchases.
As expected, on 11 December 2019 the US Federal Reserve (Fed) held its overnight lending target rate steady, keeping it within a range of 1.50% to 1.75%. In our view, this “non-news” is not what markets should be focused on. Instead, it should be the Fed’s continuing refusal to acknowledge the potential for significant dislocations in the short-term lending markets that many financial institutions rely upon to meet their funding needs. In this regard, we consider the Fed’s head-in-the-sand approach a risk in its own right to market stability, especially as we enter the crucial – and possibly high risk – final few weeks of the year.
Traditional monetary policy dialled in
We believe the Fed acted properly in keeping rates unchanged. With nonfarm payroll gains averaging 184,000 over the past 12 months, there was no pressing impetus to cut rates again after three 25 basis point (bps) reductions in 2019. Nor is the Fed compelled to raise given core inflation (as measured by its favoured gauge) is sitting well below its 2.0% goal. Despite the soundness of this decision within the context of the central bank’s dual mandate, on the matter of ensuring smooth market functioning – an objective the Fed has implicitly championed over the past several years – we believe the bank has made its task all the more difficult by failing to recognise the root causes behind this autumn’s short-term funding market upheaval.
Non-traditional policy may need some work
Rather than blaming a spike in repurchase (repo) rates on ephemeral factors such as corporate tax payments, we believe that the Fed needs to recognise that the short-term lending market infrastructure put in place in the wake of the Global Financial Crisis (GFC) is far different from what existed previously and remains largely untested. As evidenced by September’s “quiz”, this new machinery may not earn a passing grade.
We believe the source of funding issues is a shortage of liquidity. Paradoxically, this risk is largely the Fed’s own doing. Higher post-GFC liquidity requirements for banks are partly to blame but are not the entire story. Paying interest on excess reserves held at the Fed also plays a role. Rather than deploying this already-created cash to boost market liquidity, many banks seem perfectly happy earning a consistent – albeit low – return by parking it at the Fed.
Yet the biggest potential driver of market tumult is the Fed’s recent history of quantitative tightening. With the Fed ceasing to be the marginal buyer of Treasuries, banks are again bulking up on their short-term securities holdings and in turn lowering their cash balances – admittedly from elevated levels. What’s more, the aforementioned capital requirements for banks incentivise these institutions to hold Treasuries rather than lend them out in repo markets. Without investors willing to forgo their Treasury holdings, even for short periods, the functioning of short-term lending markets becomes clogged.
Waiting with bated breath
This untested market infrastructure, in our view, was the source of September’s spike in repo rates and the one-off cash payments acted solely as an accelerant. By addressing the latter at the expense of the former, the Fed risks repeating September’s tumult but by a higher magnitude given the expected end-of-year demand for cash. Increased participation in open market operations and purchasing an additional US$60 billion in Treasuries monthly, in our view, are only band-aids.
A teachable moment
Instead, the Fed would be well served by recognising the shortcomings in the repo market’s post-GFC design. To resolve these issues, it should consider lowering banks’ capital requirements, encourage them to lend out excess reserves and overtly commit to renewed balance sheet expansion rather than obfuscate its intent with what many are calling back-door quantitative easing.