Fed cut meets market expectations, but future cuts are in doubt

Repo operations remain on the horizon amid short-term funding market volatility

Sep 19, 2019 | James Ong, Marques Mercier

The Federal Reserve (Fed) cut interest rates by 25 basis points Wednesday to a range between 1.75% and 2%, as widely expected by markets. However, the Fed’s economic projections showed that the median Federal Open Market Committee (FOMC) member does not expect to cut rates again this year, marking potential disagreement among FOMC members and with markets; the bond market is currently pricing an additional rate cut this year and some FOMC members have expressed interest in future cuts.

The Fed made little change to its expectations for growth and inflation in this week’s meeting, and it made only moderate adjustments to accommodate the short-dated funding squeeze that has dogged the front end of the market this week. Wording in the press conference and statement following the meeting was consistent with views expressed in the last meeting; the Fed seems to favor keeping its options open without being locked into a single policy path.

Wednesday’s announcement appeared to disappoint financial markets. Many market participants had expected an additional rate cut to be implied by the Fed’s quarterly interest rate projections – the so-called dot plot. Investors may have also expected more dramatic measures to combat the recent funding squeeze. This disappointment will likely cause the Treasury yield curve to bear flatten in the short term, as short-term rates rise faster than long-term rates. We believe the Fed move is positive for the US dollar and negative for risk assets since the Fed may not ultimately ease financial conditions by as much as the market was expecting.

Funding market strained

Short-term funding markets have been under stress this week, resulting in sharply higher short-term funding rates, just as the Fed was seeking to lower short-term rates. A culmination of several events resulted in a surge in overnight repurchase (repo) rates on Tuesday that surprised investors and policy makers. The main catalysts for this dynamic were the coincidence of quarterly corporate tax day, high Treasury note coupon settlements and an abundant supply of Treasury bill issuance. In addition, a scarcity of bank reserves has been a contributor to upward pressure on overnight rates; reserves are currently concentrated among a few large banks despite a heightened demand for reserves within the banking sector to satisfy intraday liquidity requirements.

To help alleviate the resulting strain on liquidity, the Fed conducted overnight repo operations with a maximum capacity of US $75 billion on Tuesday and Wednesday to help stabilize overnight funding rate pressures. Funding rates subsequently decreased from a high of 8% on Tuesday to 2.50%. On Wednesday, 4.75% marked the highest level that day and the Fed repo operation quickly stabilized overnight rates to 2.45%.1 We expect the Fed to continue to conduct these temporary repo operations to gain control of funding rates until a longer-term solution is implemented. A longer-term solution could include a standing repo facility available on a daily basis to help contain funding rates within the upper and lower bound of the federal funds rate target. Another, more likely solution, in our view, would be for the Fed to strongly consider resuming its efforts to expand its balance sheet by purchasing Treasuries in the open market to help reduce excess collateral in the system. Notably, Chairman Jay Powell emphasized Wednesday that the recent funding dislocation has limited bearing on the longer-term macroeconomic outlook or monetary policy, and believes that the Fed will be able to adequately manage funding pressures going forward with the open market tools it has available.

James Ong is Director of Derivative Portfolio Management for Invesco Fixed Income. Marques Mercier is Senior Portfolio Manager and Head of Government Funds in Global Liquidity for Invesco Fixed Income.

^1 Source: Bloomberg, L.P. as of Sep. 18, 2019

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