US monetary policy normalisation tool box

stocked and ready for second rate hike

12 December 2016

Investment Research Important disclosures and certifications are contained from page 12 of this reportwww.danskebank.com/CI

Mikael Olai MilhøjSenior Analyst, International Macro Research+45 45 12 76 07milh@danskebank.com

Jens Nærvig PedersenSenior Analyst, FX & Commodities Strategy+45 45 12 80 61jenpe@danskebank.dkk

Mathias Røn MogensenAnalyst, Fixed Income Research+45 45 13 71 79mmog@danskebank.dk

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• In this presentation, we analyse the Fed’s operational framework, the current and future conditions in the

Fed funds market and the settlement of the Fed funds rate.

• At the FOMC meeting this week, we expect the Fed to raise the Fed funds target range by 25bp to 0.50-0.75%, from the current 0.25-0.50%, by setting the IOER at the top of the range (0.75%) accompanied by the ON RRP rate 25bp lower at the bottom of the range (0.50%). For more details, see FOMC Preview: Fed

set to hike – focus on outlook for 2017, 9 December.

• In our view, the ON RRP facility is likely to remain unchanged for now (except the offering rate) with no cap on the overall size but caps on individual usage, i.e. an overall size of the ON RRP facility limited only by the value of Treasury securities held outright in the SOMA (currently USD2,405bn) with each counterpart having a limit of USD30bn per day.

• We do not expect the Fed to change its reinvestment policy in 2017.

• We expect the effective Fed funds rate to remain in the middle of the target range. However, there is a risk the effective Fed funds rate could fall below the ON RRP rate over the turn of the year.

• The higher effective Fed funds rate in H2 16 appears to reflect more cautious liquidity management in the wake of the UK referendum and shifting investments by money market funds in advance of the money market reform applicable since October 2016.

Summary

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• Total USD reserves in the Fed funds system are more than USD2,000bn, i.e. well above the reserve requirement.

• Depository institutions have reserve accounts with the Fed earning the interest rate on excess

reserves (IOER), currently 0.50%.

• The large excess reserves are a result of the large bond holdings on the Fed’s balance sheet (asset side), which are financed by large bank reserves (liability side), and the IEOR, which gives an incentive to deposit at the Fed rather than lending out to the economy.

• Not all participants in the Fed funds market have

this possibility – in particular, the government-sponsored enterprises (GSEs) (Fannie Mae, Freddie Mac and the Federal Home Loan Banks [FHLBs]) and the money market funds, which need to lend to the Fed funds market.

The Fed still needs to steer the Fed funds rate with a bloated

balance sheet

Fed reserve balance and reserve requirement (USDbn)Still very large excess reserves

Source: Federal Reserve

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• Create a small shortfall in the level of bank reserves.

− Need for O/N transactions.• Push banks to bid up cash in the Fed funds market to cover the

shortfall – control liquidity injection with OMO.

− I.e. keep Fed funds rate within the policy target.• Worked when bank reserves were under USD50bn.

− Banks were not getting paid on their balances at the Fed.

• IOER: The rate that the Fed pays to banks for reserves held at the central bank.

• ON RRP: Similar to IOER, except the cash is lent to the Fed against Treasury collateral from the SOMA portfolio.− In addition to banks, eligible counterparties include large money

market funds and most of the GSEs.− In theory, the ON RRP rate should be the lowest rate in the

economy (riskless loan to the Fed collateralised with Treasuries).• While the IOER and ON RRP are both ‘floor rates’, the Fed has

created a de facto corridor system, as the effective Fed funds rate stays within the range between the two rates.

The Fed’s operational framework

Source: NY Fed, Bloomberg

Theoretically a two-tier floor system but a de facto corridor

system

Fed monetary policy rates (bp)

IOER – FF spread drivers

* Balance sheet cost* FDIC cost (deposit insurance cost)* Liquidity at banks vs at GSEs/Money Market Funds

New tools to control short-term money market rates

The Fed’s pre-crisis operating model

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• In the absence of market friction, depository institutions would arbitrage out the spread between the Fed funds

rate and the IOER.

• Regulatory issues reduce the incentive of depository institutions to increase their balance sheets, as costs

rise with the size of the balance sheet, in particular over turns.

• This implies that the Fed funds rate has a margin to the

IOER. In order to have a handle on this margin, the Fed

uses the ON RRP facility to drain reserves .

• The higher effective Fed funds rate in H2 16 appears toreflect more cautious liquidity management in the wake of the UK referendum and shifting investments by money market funds in advance of the money market reform applicable since October 2016. The FOMC’s minutes from the July 2016 meeting state the following.− The modestly higher average effective Fed funds rate than in the previous

intermeeting period ‘appeared to reflect at least in part more cautious

liquidity management by some money market participants in the wake of

the UK referendum’.− The rising take-up of the system's ON RRP facility ‘seemed to be in

part the result of shifts in investments by money market funds in advance

of the scheduled implementation in October of changes to the regulation

of the money market fund industry’.

Settlement of the effective Fed funds rate with this ‘new’

framework

Visible turn effects and a generally higher effective Fed

funds rate in H2 16

Fed monetary policy rates (bp)

Source: Federal Reserve, Danske Bank Markets

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• While IOER is available only to depository institutions, ON RRP can be made available to non-bank investors that are active in the money market.

• The list of eligible counterparties for the ON RRP facility

is thus broader and includes money market funds, GSEs such as Fannie Mae, Freddie Mac and FHLB and primary dealers (see list).

• In general, any counterparty that is eligible to participate in the ON RRP facility should be unwilling to invest funds

overnight with another counterparty at a rate below the

ON RRP rate.

• Hence, in practice, the effective Fed funds rate will be below the IOER but above the ON RRP rate.

• The increasing outflow from prime money market funds into government money market funds ahead of the US money market reform applicable from October 2016, seems to have increased the take-up at the ON RRP facility.

• There is still room for further use of the ON RRP facility.

The total use of RRP (both ON and term) has so far not been above USD640bn, which is well below the current USD2,405bn overall effective cap, i.e. the available amount of Treasuries to lend out.

The Fed’s key instrument - the ON RRP facility, the basics

Note: Details after 30 June 2016 not disclosed

Source: Federal Reserve, Bloomberg, Danske Bank Markets

Allotted amount in the ON RRP facility in different segments

Daily ON RRP allotment (USDbn)

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• Since December 2015, the overall size of the ON RRP facility has been limited only by the value of Treasury securities held outright in the SOMA and each counterparty has a limit of USD30bn per day.

• The number of eligible counterparties for the ON RRP facility and the limit of USD30bn per counterparty implies an overall ON RRP facility size cap of approximately USD4,000bn, Hence, the effective cap for the ON RRP facility is the value of the Treasury securities held outright in the SOMA, i.e. USD2,405bn, as of 7 December 2016.

• The offering rate is currently 0.25bp, i.e. the spread between the IOER and the ON RRP is 25bp.

• At the November 2016 meeting, Fed Chair Janet Yellen reiterated that ‘additional experience with the

Federal Reserve’s current monetary policy implementation framework would help inform policymakers’

future deliberation of issues related to a long-run framework and that decisions regarding these issues

would not be required for some time’.

• Furthermore, according to Fed staff, the ON RRP facility remains an important element of the operating

regime with abundant supply of reserve balances and it could also be effective with an appreciable smaller balance sheet and supply of reserves.

• Hence, the ON RRP facility is likely to remain unchanged for now (except the offering rate) with no cap on

the overall size but caps on individual usage.

• However, financial stability arguments suggest limiting the ON RRP facility as the facility might exacerbate disruptive flight-to-quality flows during a period of financial stress.

The Fed’s key instrument- the ON RRP facility

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• We expect the effective Fed funds rate to stay in the

middle of the target range. Hence, another 25bp rate hike

would leave it around 0.625%.

• The market is currently pricing the effective Fed funds rate to settle around 0.65% and at 0.50% over the turn of the year.

• In 2015 before the Fed hike, the marked priced the effective Fed funds rate to settle around 0.32% and at 0.27% over the turn of the year. Initially the effective Fed funds rate settled around 0.36-0.37% and at 0.20% over the turn of the year.

• We see a risk that the effective Fed funds rate may fall

below the ON RRP rate over the turn of the year, as it did

a year ago.

• The cap on the use of ON RRP has not changed since last year, when it was not sufficient to keep the Fed funds rate within the target range.

• Furthermore, new regulation comes into effect from 1 January, i.e. US banks are required to hold LCR of 100%.

We expect the effective Fed funds rate to stay in the middle of the

target range – risk of fall below ON RRP rate over turn of year

Fed funds effective to IOER and ON RRP at lift off

Fed policy rates, current and lift-off expectations, bp

Source: Federal Reserve, Danske Bank Markets

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0

50

100

150

200

250

300

350

400

450

500

2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046

Par Value (USD bn)

Maturity

Agencies FRN MBS Notes and Bonds TIPS

Reducing the balance sheet- a longer term issue

Note: current face value used as par value for MBSs

Source: Federal Reserve, Danske Bank Markets, 7 December 2016 data

• In the statement from the FOMC meeting in December 2015, we learnt that the FOMC anticipated that it would continue to reinvest ‘until normalisation of the level of the Federal funds rate is well under way’.

• In 2016, there has been no change to reinvestments and no further discussions regarding the reinvestment policy.

• We do not expect the Fed to change its reinvestment policy in 2017, because the Fed will, in our view, not be ‘well under way’ with only two additional hikes and because it seems to us that the Fed is closer to accepting that large balance sheets may be a more permanent part of the Fed’s operational framework.

• If the Fed ends reinvestments, it is likely to do so gradually. Letting the balance sheet run down without smoothing would mean a very choppy reduction.

Fed’s bond portfolio

System Open Market Account (SOMA)4.205bn

0% 0%

41%

56%

3%

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Appendix

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• Liquidity coverage ratio (LCR): this generally discourages short-term borrowing (< 30 calendar days) in the money market.

• Implementation of LCR started in 2015 and it will be fully implemented in the US from 1 January 2017, when banks are required to have an LCR of 100%.

• LCR is measured on an ongoing daily basis, which means that it has a permanent impact on the market.

• It has a permanent negative impact on the demand for Fed funds and a permanent positive impact on demand for reverse repos and thus a permanent negative effect on the supply of reserve balances.

• Leverage ratio: this generally gives a disincentive to build-up exposure. It is derived differently for different segments of banks and depends on on-balance sheet and off-balance sheet items.

• For some it is calculated on daily averages, for some on the basis of the average of the month-end balance sheet and for some on the quarter-end balance sheet. i.e. the market impact is to some extent temporary around month-end and quarter-end.

• Net stable funding ratio will be introduced in 2018. It will create a further disincentive to borrow in the short-term money market.

Impact of Basel III on the Fed funds market

Significant negative impact on US monetary base on

quarterly basis

Upper: USDtrn, lower: USDbn

Note: The Federal Reserve may conduct reverse repurchase agreements with foreign

official and international accounts as a service to the holders of these accounts. The Fed

Reverse Repos time series in the chart above contains both these reverse repo

agreements and transactions with primary dealers and other counterparties who have

been established specifically to transact in reverse repurchase agreements.

Weekly frequency data (middle of period).

Source: Federal Reserve, Danske Bank Markets

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• The US money market reform (MMR) was adopted in July 2014 and came into effect on 14 October 2016.

• The key elements of the US MMR are the rules for f loating net asset value (NAV) and the liquidity fees and redemption gates, i.e. as follows.− NAV: The MMR introduces a floating NAV for sales

and redemptions based on the current market value of the securities in the portfolio, instead of a stable USD1 share price. Hence, the risk of ‘breaking the buck’ (NAV going below USD1) has, all else being equal, increased.

− Liquidity fees and redemption gates: The MMR provides new tools to money market funds to address a potential run on a fund. The new tools will give funds the ability to impose liquidity fees or to suspend redemptions. They will be enacted if a fund’s level of ‘weekly liquid assets’ falls below a certain threshold.

• Importantly, government money market funds are

allowed to continue using the amortised cost method

and are not subject to the new fees and gates provisions.

• For more details, see The US Money Market Reform: The

Scandi Angle, 9 August.

• A money market fund that invests primarily in corporate debt

securities.

• A money market fund that invests 99.5% (formerly 80%) or more of

its total assets in cash, government securities and/or repurchase

agreements that are collateralised solely by government securities

or cash.

The US money market reform- shift in investments, key elements

The outflow from prime money market funds into

government money market funds accelerated ahead of

14 October 2016

Assets under management (USDtrn)

Government money market fund

Prime money market fund

Source: Investment Company Institute

Source: US Securities and Exchange Commission

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Disclosures

This research report has been prepared by Danske Research, a division of Danske Bank A/S (‘Danske Bank’). The authors of this research report are Mikael Olai Milhøj, Senior Analyst, Jens Nærvig Pedersen, Senior Analyst and Mathias Røn Mogensen, Analyst.

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