It’s been less than a month since the Federal Reserve resumed its Supplementary Financing Programme in a bid to begin draining liquidity, but the effects are already creeping into the rate market.
Note the rise in overnight dollar-Libor rate here:
And also here in the OIS one-month swap rate:
The SFP’s resumption will eventually bring up to $200bn worth of collateral back into the market in the interim period. The thing to consider, though, is whether it’s all been a bit too much for the market to take on already.
As Barclays Capital’s Monday collateral report explained, absorption problems are appearing (our emphasis):
The repo market’s inability to easily absorb the extra $200bn worth of collateral supply created by the re-introduction of the SFB program has been a major surprise.
The regular monthly settlement of the 2y, 5y, and 7y auctions (which typically are about $90bn) have in the past year only caused a brief back-up in collateral rates of just a couple of basis points.
Clearly, the SFB program’s return was the straw that broke the camel’s back – instead of moving back to pre-debt ceiling levels of 15bp, general collateral has overshot and has averaged about 18bp in the past week. There is nothing in the near-term supply outlook to cause that to change – the Treasury will sell a net $21bn in bills this Thursday, which is hardly enough to push repo rates much heavier than they already are.
Pushing repo rates ‘much heavier’ means seeing them cheapen. Which means Barclays believes that (for the time being at least) the market may have reached some sort of saturation point.
Although it’s not a situation the bank’s analysts believe will last for long. The market still has a further $125bn of coupons and bills to be introduced over the next two months. This, they say, will likely see repo rates trade ‘heavier’ over the next month, rising as high as 20 basis points before retracing ahead of a more pronounced Fed tightening announcement, involving reverse repos.
Eventually those interim rate increases will also feed through to Libor and OIS swap markets. Although whether that’s down to the technicalities of too much collateral in the market, or outright Fed tightening policy, is more difficult to say. As Barclays Capital explain:
With a lag, Libor and OIS rates have begun moving higher, and the heaviness in repo may provide 3m Libor with enough momentum to breach 30bp. However, these technical factors are uncorrelated with any move by the Fed to drain reserves or tighten policy.
Instead, our economists expect the Fed to raise interest rates in September – which may be a few months earlier than the consensus. With reverse repos unlikely to begin until late June at the earliest, our sense is that markets may be over-reading what to us seems to be a purely technical reaction to an overabundance of collateral in the repo market.
Instead, we find the tightening the correlation between repo and the effective funds rate over the past two weeks to be much more intriguing. This suggests that the market’s expectation that an oversupply of collateral from the Fed’s reverse repos would cause GC to invert to OIS – that is, trade an average of 8bp higher than the prevailing OIS rate in Q4 10 might be too optimistic.
That said, we were under the impression that one of the SFP program objectives was indeed to apply upward bias to interest rates?
In which case, the policy does appear to be working.
Related links:
Operation Drano – FT Alphaville
A discreet draining operation? – FT Alphaville
Bernanke in the dock over exit strategy – FT
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