personal views of a former fed trader

The Elasticity of 5 Basis Points

Large money market investors will move billions for even a basis point. A 5bps increase to the RRP offering rate led to a $200b+ surge in participation, but there is a wrinkle to the story. The bulk of the increase likely came from Government Sponsored Enterprises (“GSEs”) who were leaving hundreds of billions at 0% in their Fed account, so it was not an incremental flow from the private sector. That being said, the 5bps increase puts money market funds (“MMFs”) in a position to offer their investors a few basis points in yield. This will make it easier for banks to continue to push out their high cost deposits. The departed deposits will quickly be replaced by the constant flow of low cost deposits created from Fed financed deficit spending. In this post we shed light behind this week’s RRP surge, the improving funding profiles of banks, and why this means FRA-OIS will continue to narrow.

Why did the RRP surge this week?

Some GSEs prefer to leave cash at Fed rather than invest in repo at 1bps

The 5bps RRP tweak likely drew in substantial participation from the GSEs, a class of investors who have accounts at the Fed but do not receive IOR. As repo rates moved toward 1bps, some GSEs simply left their balances un-invested at the Fed. The 1bps return in repo may not have been adequate to compensate for operational and counterparty risk. Public Fed balance sheet data does not break out GSE deposits, but lumps them in the “Other” category (which includes also includes clearinghouses etc.). However, a drop in repo rates coincides with a $200b increase in “Other” deposits. Furthermore, recent public filings from Freddie Mac show that that they left $100b un-invested at the Fed rather than their usual allocation to repo.

Freddie Mac left $100b cash at Fed instead of investing at 1bps in repo. Source: Freddie Mac March 2021 10-Q

The GSEs are big participants in money markets, especially Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Fannie Mae is well known in the market for its “float period,” which is when it receives mortgage payments from homeowners and reinvests them for a few days before remitting them to Agency MBS holders. In times of high mortgage prepayments the incremental “float period” cash can exceed $100b. But all GSEs have liquidity to invest each day both from their business and from regulatory liquidity buffers (the FHFA mandates something similar to the LCR – see here and here). GSEs collectively usually have around $300b in liquidity that can be invested in money markets. Going forward, a chunk of that will be in the RRP each day.

Note that MMFs were unlikely a major driver of Thursday’s surge in RRP participation. An RRP hike instantly raises all money market rates so the relative attractiveness of the RRP is little changed. MMFs also tend to buy and hold, and would have realized MTM losses on bills if they did sell. But over the coming weeks MMF participation will continue to steadily grow as some maturing bill proceeds are reinvested into the RRP (short bills are trading below RRP now) and overall MMF assets increase. As noted before, persistently high RRP participation is structural and will steadily increase to over $1t this year.

Banks Welcome Deposit Outflows

Broadly speaking, deposits can be categorized as stable and rate insensitive retail deposits or rate sensitive wholesale deposits. Basel III essentially places limits on the amount of deposits banks can accept, and assigns higher regulatory costs to wholesale deposits (see this post). This has led banks to “push out” high cost deposits. Now there will also be a slight “pull” factor of a few bps from money markets that will make the conversation go a bit more smoothly. (Note that $1b invested overnight at 1 bps earns just $277, so the pull is slight). The deposits who leave for an few extra bps elsewhere are exactly the deposits the banks want to push out. Those rate sensitive deposits will quickly be replaced by the constant flow of Basel III friendly retail deposits who are happy with 0% interest.

One way to look at QE and massive deficit spending is to consolidate the Fed and Treasury. In this view, the Fed is creating money out of thin air and shipping it to the Treasury to be spent. That’s not literally what happens, but the outcome is the same. Treasury spends the new money on salaries, transfer payments, tanks etc. A lot of the spending is going directly to the bank accounts of retail, or at least to corporations (who are also considered low cost depositors). This means low cost deposits are continually and rapidly being pumped into the banking system. Banks will eventually be completely funded by low cost and stable retail or corporate deposits.

Bank of America’s significant shift away from wholesale funding post-Basel III is illustrative of GSIBs in general. Their significant liquid asset holdings combined with a structural shift towards a stable retail deposit base make liquidity runs virtually impossible. Everyone who would run has either already ran or got pushed out. Of course, if a bank wanted to retain a depositor it could easily afford a few bps now that IOR is at 0.15%. But that won’t be necessary – their retail funding base is growing each day.

Big banks have moved away from wholesale money markets. Core and Non Core is a rough proxy for retail and wholesale.

In the post Basel III world, unsecured money markets exist primarily as a service for the benefit of a bank’s client and not the bank. The regulatory costs of using unsecured money markets is high and cheap retail or corporate deposits are abundant, so banks must be paid to borrow in unsecured money markets. That payment is the spread between IOR and the borrowing rate (see this recent paper). The bank’s client in turn receives a return slightly higher than the RRP. The right price for 3M Libor in today’s environment is a few basis points below IOR (see this post). As long as QE continues and leverage ratios exist, FRA-OIS will narrow.

The Fed is Evolving

The Fed tweaked the RRP/IOR rate even though EFFR was solidly in the target range. The April FOMC minutes show a concern for overnight rates, which include the much more important overnight repo market. EFFR has long been irrelevant in the financial system, and it appears that the Fed may finally be acknowledging this. Looks like repo (and short bills) dipping negative was enough to prompt a move. The RRP is a sound floor for EFFR and tri-party repo, but not bills. Bills (and agencies) have traded several basis points below the RRP offering rate for extended periods of time in the past, and can move back towards 0% in the coming weeks as bill supply shrinks. The RRP is not a floor for dollar rates. Further technical adjustments can happen when rates again flirt with negative.

This was a pretty strong hint that an adjustment is coming

7 Comments

  1. John Ahearn

    I think the assumption that Fiscal support is still forthcoming is not a certainty yet. We will need to see how that progresses, there are politics to consider that might prefer to see the current administration fail that wouldn’t care if they destroyed the finances of a few million boomers in the process.

    Or, we just need a good market scare to get those “pesky” politicians back in line.

    But otherwise from what I have read as a person who follows this as a hobby, I align well with your take. Thanks for the post, I was wondering where the hell the extra 200 billion was suddenly coming from.

  2. Yu

    Big fan of your work, just ordered your book.. thx

  3. izzy

    Very interesting comment! I have a few questions, Hopefully someone can help me. The counterparties in RRP have 27 MMFs with 92 funds associated with them. The counterparty posted in Fed website based on the 27 MMFs or based on each fund as a separate counterparty? In addition, there are 77 counterparties in small test trades a few days ago. So are there total 77 counterparties (MMF + GSE + Banks + Primary Dealers) ? Thanks all for your help!

    • Fed Guy

      Each fund is a separate counterparty. A big fund manager like Blackrock or Fidelity will have multiple funds, each RRP counterparties.

      • izzy

        Thanks for your insight! That means there are over 150 counterparties in RRP. Each one will have $80bn cap. There is a lot of capacity that the RRP needs to accommodate if needed.

  4. Dean

    Hey Fedguy, have a question but it’s unrelated to this post but I can’t ask it on the relevant post. It’s about your BRRR index, May I ask if when you plot the fiscal flows are you netting the amount of issues and redemptions out of the amount? In other words, are you just plotting total withdrawals – total deposits, or are you plotting (total withdrawals – total redemptions) – (total deposits – total issues)? Cheers

    • Fed Guy

      The BRRR index shows the amount of deficit financed spending, so it is essentially net Treasury issuance less build up of the TGA account (Money in TGA is not yet spent).

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