Don’t Call It a Rate Cut
Prior Week Summary
The interesting economic news of the week centered around a rather technical aspect of the Fed’s approach to conducting monetary policy that was outlined in the May FOMC meeting minutes. The minutes described the relationship between the interest paid on excess reserves (IOER) and the federal funds target range and stated it “could become appropriate to make a small technical adjustment in the Federal Reserve’s approach to implementing monetary policy by setting the IOER rate modestly below the top of the target range for the federal funds rate.” The minutes continued to say, “this could be accomplished by implementing a 20 basis point increase in the IOER rate at a time when the Committee raised the target range for the federal funds rate by 25 basis points. Alternatively, the IOER rate could be lowered 5 basis points at a meeting in which the Committee left the target range for the federal funds rate unchanged.”
The market interpreted this technical adjustment as “dovish” in that it implies that the Fed is endeavoring to lower the market’s expectations for increases in the fed funds rate relative to the current pricing implied by futures and OIS. The concern emanates from the fact that fed funds has been drifting higher to trade consistently closer to the top end of the fed’s target range, rather than the midpoint. By reducing the rate paid on excess reserves, the Fed is attempting to influence the fed funds rate lower by incenting cash to move into the repo market, the fed funds market or other cash alternatives which could serve to push the effective fed funds rate closer to the midpoint of the target range. The need for the Fed to change their approach to managing the fed funds rate, which is critical to the process of conducting monetary policy, is a direct result of the meaningful increase in Treasury supply and the need for the global capital markets to finance our growing twin deficits, and the associated increases in the return demanded by the market to finance treasury collateral. As one data point, the Treasury intends to auction $130 billion in bills this Tuesday alone.
Not surprisingly, the market re-priced the front-end of the fed funds curve a few basis points lower in response to the fed minutes. While the math associated with quoting the probabilities of hikes at specific Fed meetings will need to be updated given the change in the Fed’s approach, there is still a very strong indication of a hike at the June meeting.
The Look Forward
In addition to absorbing a large amount of Treasury supply, the market will look forward to an active calendar of data releases, including updates on 1Q GDP, personal income and spending, and the May employment report.
Sources: Bloomberg Finance L.P., (Treasuries) Chatham Financial (Swap Curves), FHLB Boston, Chicago, Dallas, Des Moines for FHLB Advance Rates. Wells Fargo Brokered CD Indications.
Market Implied Policy Path (Overnight Indexed Swap Rates)
Source: Chatham Financial
Fixed Income Snapshot
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