You wouldn’t know the Federal Reserve has done nothing but add to its record monetary stimulus from looking at short-term funding markets.
The federal funds effective rate on overnight loans between banks was 0.16 percent on Nov. 21, up from 0.06 percent at the end of September 2011, the month Fed officials announced they would begin swapping short-term securities in their portfolio for long-term debt under Operation Twist. The rate for borrowing and lending Treasuries for one day through repurchase agreements also has surged.
Higher overnight interest costs are a side effect of Operation Twist that has persisted despite new accommodation, including a third round of quantitative easing and extending the horizon for near-zero borrowing costs through mid-2015. When the program ends in December, the Fed will have shrunk its portfolio of short-term securities by $667 billion through Twist sales and redemptions, designed to lower long-term interest rates while keeping the size of the Fed’s balance sheet constant.
“There have to be distortions whenever you get the Fed intervening to affect the shape of the term structure,” said Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who’s now chief monetary economist at Cumberland Advisors Inc. in Sarasota, Florida. “There’s no free lunch.”
The Fed’s sale of short-term Treasuries has put record amounts of these securities on primary dealers’ balance sheets, increasing their financing costs. As of Nov. 14, the 21 primary dealers that trade directly with the Fed held $69 billion of Treasury coupon securities due in three years or less, compared with $1.8 billion on Oct. 5, 2011, Fed data show. That’s down from a record $76.9 billion on July 25.
The glut has helped drive repo rates higher, as the firms typically use the securities as collateral for temporary loans through the overnight lending market as a way to help finance their holdings. A repo typically involves the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender.
When the amount of debt dealers need to finance through the repo market increases, rates typically rise to attract more lenders, which are primarily money-market mutual funds. During the height of the global financial crisis in 2008, when Treasuries were in short supply amid global demand for the debt as a haven, repo rates collapsed to nearly zero given the supply shortage.
The overnight repo rate for Treasuries climbed to 0.288 percent as of Nov. 23 from minus 0.001 percent on Dec. 30, a Depository Trust & Clearing Corp. general-collateral finance repo index shows. The index has averaged 0.258 percent in the last month, compared with 0.096 percent in 2011.
“The ultimate purpose of all that the Fed has been doing is to create an abundance of cheap credit available in the economy,” said Boris Rjavinski, interest-rate derivative strategist at UBS AG in Stamford, Connecticut. “Yet, primarily as a result of Twist, the repo rate has been stubbornly high, especially compared to other short-term lending benchmarks.”
Distorted repo rates increasingly matter because the money-market metric has gained stature as bankers and investors seek alternatives to the London interbank offered rate, known as Libor. Regulators across the globe are investigating claims that banks altered submissions used to set Libor to appear financially healthier or benefit traders.
An industry group has proposed the repo rate as a potential benchmark for a floating-rate note program the Treasury Department is developing. The Treasury Borrowing Advisory Committee, made up of bond dealers and investors who meet quarterly with the government, suggested a DTCC repo index as one of its choices.
The Fed has turned to unconventional easing tools, such as Twist, after lowering the target for its benchmark fed funds rate to a record low between zero and 0.25 percent in December 2008. In 2007, before the worst recession since the Great Depression, the rate was above 5 percent.
The central bank’s balance sheet and communications have been its main policy levers, and the Fed in September announced it would buy $40 billion of mortgage debt a month without setting a limit on the size or duration of the program.
Operation Twist, extended in June of this year, is scheduled for completion by year-end as the Fed holds less than $80 billion of debt maturing through 2015, almost all of which will be sold by then. A “number” of Fed officials said the central bank may need to expand its monthly purchases of bonds next year, according to the minutes of the Federal Open Market Committee’s Oct. 23-24 meeting.
Twist has succeeded in helping cut longer-term borrowing costs, with the yield on the benchmark 10-year Treasury note at 1.69 percent on Nov. 23, down from 1.92 percent on Sept. 30, 2011, according to Bloomberg Bond Trader prices.
“Long-term rates have gone down, and that was the objective,” Eisenbeis said. “Fed people and Bernanke have argued strenuously that it’s been very successful.”
On Oct. 24, 2011, Brian Sack, then markets group chief and now a senior adviser at the Federal Reserve Bank of New York, said while Operation Twist had “gone well,” he was surprised by the “upward pressure” on short-term rates. The New York Fed’s markets group is responsible for executing monetary policy and managing the central bank’s bond portfolio.
“You get unforeseen consequences” when pursuing unorthodox policies, said Allan Meltzer, a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh and author of a two-volume history of the Fed.
Jack Gutt, a spokesman for the New York Fed, declined to comment.
In 2010, the Fed’s mortgage-bond buying made some securities so hard to find that Wall Street couldn’t complete an unprecedented number of trades. An industry group rectified the problem in 2012 by instituting penalties for dealers and investors who fail to complete transactions in agency debt and home-loan bonds.
Several times this year, rising repo rates have left dealers with financing costs that were higher than short-term-debt yields. The yield on the benchmark two-year note averaged 0.27 percent during the last month, nearly matching the average general collateral repo rate. When funding costs are above debt yields, so-called carrying costs are negative, increasing the potential for losses on trades.
“For collateral providers in the repo market, such as dealers, the rise in rates has increased their costs and reduced their income,” said Jeff Kidwell, director of funding and Direct Repo at Boca Raton, Florida-based broker dealer AVM LP. “Money funds and corporations, who provide the cash, have seen a windfall with the rate increase and a greater availability of collateral.”
The completion of Twist in December is likely to alleviate pressure on short-term funding costs, according to UBS and Citigroup Inc. analysts.
The end “will be one of the factors that will help bring repo rates down” next year, said Andrew Hollenhorst, fixed-income strategist at Citigroup in New York, during an interview on Oct. 30. Treasury repo rates probably will fall to slightly below 0.15 percent by the second half of 2013, he forecasts.
Twist has led to distortions between the cost to borrow in the repo market on a secured basis and unsecured rates such as Libor, said Alex Roever, head of short-term fixed-income strategy at JPMorgan Chase & Co. in Chicago. The overnight Libor rate was 0.155 percent on Nov. 23, cheaper than the repo market’s 0.27 percent, according to an index compiled by ICAP Plc, the largest inter-dealer broker of U.S. government debt.
“Historically, this is not normal, as secured lending should be less expensive,” Roever said.
The rise in overnight repo rates has caused the fed funds effective rate to drift higher, with Nov. 21’s 0.16 percent, up from 0.04 percent at the end of last year. The measure has averaged 3.2 percent during the past 20 years and is still within the Fed’s target range of zero to 0.25 percent.
The rate, a volume-weighted average on trades by major brokers published daily by the New York Fed, also has increased as overnight loans between banks have dwindled, another byproduct of the Fed’s unprecedented monetary easing since 2008.
Daily bank demand for fed funds, which historically helped keep the effective rate near the target, has slid as the Fed has tried to spur growth through more than $2 trillion in debt purchases. This caused a surge in the excess bank reserves it holds to $1.44 trillion on Nov. 14 from $2.2 billion in 2007.
Dysfunctional short-term markets may make it more difficult for central bankers to tighten policy when they desire, Meltzer said. The Fed has historically moved the fed funds rate by buying or selling Treasury securities, adding or withdrawing cash from the system.
“Ultimately the Fed is going to want to go back at some point to its former procedure of operating through the fed funds market,” Meltzer said. It “doesn’t seem to work anymore.”