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would argue that resolving this issue would help the
Fed regain better control of overnight rates. In fact,
the Fed might also be already considering reverse
repos with GSEs, as it has not yet specified which
counterparties are under consideration.
Bernanke outlined a key change in the Fed’s
approach which could help it gain stronger control of
short-term rates. The Fed will shift its policy target to
the rate paid on reserves instead of the fed effective
rate during the early stages of tightening. Effective
fed funds has occasionally been driven much lower
than expected as the banking system dumps
reserves in that market on days of excessive liquidity.
This makes it difficult for the Fed to control effective
rates during the early stages of rate increases. By
protecting against unexpected plunges in the Fed
effective rate, this should force an upward
adjustment to OIS, GC and even Libor, although
perhaps only slightly since most of the time there is
not a dramatic drop in effective rates.
Offering term deposits
This isn't the first time a potential Term Deposit
Facility has been mentioned by the Fed. The
implication of introducing such a facility, especially
ahead of rate hikes, is that it could give the Fed
effective control of rates longer than 1m or even 3m.
As another tool for draining liquidity, the Fed "plans
to offer to depository institutions term deposits, which
are roughly analogous to certificates of deposit that
the institutions offer to their customers".
By offering deposit out to (say) 3m, the Fed could
arguably directly control the 3m rate, besides the
traditional overnight fed funds rate. Although an
argument can be made that investors will set the
rate, the Fed could nevertheless influence it by
adjusting the supply of its offerings. Therefore, if the
Fed starts to use this facility before official rate hikes,
it could at the very least increase volatility and quiet
possibly push up short rates. Testing of the TDF is
scheduled to start in the spring on a small scale,
implying that the use of this facility will scale up as
the economy improves.
Therefore, considering that the Fed has hinted that
liquidity draining exercises will ramp up before official
rate hikes, we could see the potential impact on rates
as early as mid-to-late spring. As such,
carry/rolldown plays should be considered with this in
mind.
On discount window, TAF and TALF wind-down
The Fed’s current outstanding discount window
borrowing is down to USD 89bn from a crisis peak of
USD 438bn. Therefore, the discount window is barely
used despite the Fed’s intense promotion of the
facility at the start of the crisis. The idea was that
banks would be willing to borrow from the Fed in
case Libor rates were higher, thus making the
discount window a “cap in Libor”. This failed the test
and so other liquidity programmes were needed.
Thus, a raise in the discount rate is unlikely to
increase Libor (or other short-term rates) although
some investors will surely still regard this as a
hawkish message.
Likewise, we expect no noticeable impact from the
wind-down of other facilities, such as TAF on 8
March and TALF on 31 March (30 June for CMBS
collateral) as utilisation of these programmes has
dwindled recently.
Asset sales
Lastly, security sales shouldn’t be a concern in the
short/medium term, as the Fed doesn’t anticipate
selling security holdings “at least until after policy
tightening has gotten under way and the economy is
clearly in a sustainable recovery”.
Bernanke has used very careful and measured
language in providing a detailed update on the Fed’s
exit plan. By filling in the holes in the plan, investors
are now able to envision the exit path more clearly
and some may even be bracing for hawkish
messages at upcoming FOMC meetings/speeches.
Thus, while Bernanke may insist there has been no
policy shift, the market reaction in the coming weeks
may prove otherwise. We stick with the bearish call
we made at the start of the week.
Sergey Bondarchuk / Suvrat Prakash / Bulent Baygun 12 February 2010
Market Mover, Non-Objective Research Section
17
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