The Federal Reserve impacts the economy by raising and lowering the Federal Funds Rate. With the Fed Funds rate currently at a range of 0-.25%, the Federal Reserve has no more ammo to positively impact the economy, right? No! Readers of Sense on Cents are fully aware of the other measures the Fed, in conjunction with the Treasury, has utilized to inject money into the economy, including:
- quantitative easing in which the Fed has purchased U.S. Treasury and mortgage-backed bonds
- backstopped money market funds (FYI . . this program ended last Friday)
- providing federal guarantees for banks to issue debt
- facilities to assist in the issuance of securitized assets (TALF)
Collectively, these programs have achieved an effective negative Fed Funds Rate. This development is not only historic but very daunting for the economy and market. When and how will the Federal Reserve and Treasury begin to exit some of these programs, and take some liquidity out of the system without spooking the markets? In the process, the Federal Reserve will begin a de facto tightening of the monetary policy even if it does not immediately begin to raise the Fed Funds Rate.
This tightening process may be in its formative stages. How do we know? Bloomberg reports, Fed Said to Start Talks With Dealers on Using Reverse Repos:
The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.
Central bank officials are discussing plans to use so- called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That’s where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.
Given the amount of liquidity the Fed has pumped into the economy over the last year, these reverse repurchase agreements would have to be of huge size and for a longer tenor in order to truly make an impact.
What would be the impact of sizable reverse repurchase agreements? I would make the following assessments based upon my feeling that the market would perceive these agreements as a tightening of Fed policy:
- the yield curve would flatten, meaning short term rates would raise relative to long term rates (revisit your Algebra II chapter on slope)
- the U.S. dollar would strengthen as the market perceives this move an indication that the Fed is closer to raising the actual Fed Funds Rate than it was previously.
- the markets, both equities and bonds, would very likely sell off in a reversal of the price action of the last six months. Both our equity and bond markets have been supported by the cheap funding provided by the Fed. This phenomena led to the dollar carry trade which I highlighted a week ago in writing, “Dollar Carry Trade Drives Global Equity Markets.”
The dollar is getting hammered again today and that fact is supporting our markets, both equity and bonds. Watch the US Dollar Index as it is clearly the best indicator as to the Fed’s intentions and market direction. If and when you see the dollar start to improve (currently quoted at 76.13), then look for stocks and bonds to weaken.