The Possibility of Federal Reserve Interest Rate Cut in March is Low
The Possibility of Federal Reserve Interest Rate Cut in March is Low
Exploring the improbability of a Federal Reserve interest rate cut in March.
The CME FedWatch Tool
The CME FedWatch Tool helps market participants assess expectations for changes in the Federal Reserve's target interest rate. Using the Fed Fund target rate as a basis, it measures market expectations for Fed Fund rate changes through Fed funds futures contract prices. This tool acts as a barometer, offering insights into market perceptions of upcoming Federal Open Market Committee (FOMC) meetings and potential interest rate adjustments.
The current market sentiment, as reflected by the CME FedWatch Tool, suggests a low likelihood of a Federal Reserve interest rate cut in March 2024, with a probability of 76.9%. This indicates that market participants anticipate the Fed to maintain or potentially raise the interest rate during that period.
The Background of The Current Federal Reserve Bank of Dallas
Lorie K. Logan currently serves as the President and Chief Executive Officer of the Federal Reserve Bank of Dallas. She assumed this role following her appointment on May 11, 2022. Before her position at the Dallas Fed, Logan managed the Federal Reserve Bank of New York's significant holdings of securities and cash.
https://www.dallasfed.org/fed/leadership/logan
The Overnight Reverse Repurchase Agreements (RRP)
The Federal Reserve uses Overnight Reverse Repurchase Agreements (RRP) as a tool for monetary policy implementation.
The process (reverse repos) works as follows:
The Federal Reserve sells securities to eligible counterparties with an agreement to repurchase them the next day at a slightly higher price.
Counterparties pay for these securities, and the funds are transferred from the clearing bank to the New York Fed, reducing bank reserve liabilities.
The next day, the Federal Reserve repurchases the securities at a slightly higher price.
This tool assists in controlling short-term interest rates and managing the level of reserves in the banking system.
Repurchase Repos (Repo): Counterparties sell securities with an agreement to repurchase them later at a higher price to the Fed. It injects liquidity into the market.
Reverse Repurchase Repos (Reverse Repo): Counterparties buy securities with an agreement to repurchase them from the Fed. This drains liquidity to reduce the overall money supply.
Recently, Dallas Fed President Logan's Remarks:
https://www.dallasfed.org/news/speeches/logan/2024/lkl240106
Dallas Fed President Lorie Logan raises concerns about liquidity constraints tied to the decline in the use of the Federal Reserve's overnight reverse repurchase agreements (RRP). As RRP balances approach low levels, Logan advocates slowing asset runoff to preserve financial system liquidity.
The focus should shift to liquidity concerns rather than interest rates, as large-scale asset price performance during the current monetary policy tightening cycle indicates that capital liquidity impact surpasses interest rate effects. Past financial crises often resulted from sudden liquidity shortages, hindering key asset refinancing and escalating the liquidity spiral.
The Market Liquidity Indicators
https://www.federalreserve.gov/releases/h41/current/h41.htm
The Federal Reserve's balance sheet is an important indicator of financial market liquidity. On the asset side, it is characterized by key components:
Holdings of Securities: Treasury bonds and Mortgage-Backed Securities (MBS), reflecting the Federal Reserve's investment portfolio.
Loans: Currently, there is a particular emphasis on the Bank Term Funding Program (BTFP), introduced as a new account after the Silicon Valley Bank (SVB) incident last year to provide additional funding to eligible depository institutions, supporting American businesses and households.
These elements on the asset side reflect the Federal Reserve's holdings and activities, providing insights into the overall liquidity and health of the financial market.
The liability side of the Federal Reserve's balance sheet encompasses various components:
Commercial Bank Reserves: These are funds held by commercial banks at the Federal Reserve, influencing the overall money supply and banking system liquidity.
Cash: Representing physical currency in circulation, cash is a liability on the Federal Reserve's balance sheet.
Reverse Repurchase Agreements (RRP): RRP involves the Federal Reserve borrowing funds from financial institutions, serving as a money market fund. Financial institutions store excess cash in the Federal Reserve temporarily to gain risk-free returns.
Treasury General Account (TGA): TGA is the U.S. Treasury's account at the Federal Reserve, functioning as a checking account for official receipts and payments of the U.S. government.
Market liquidity is influenced by several key variables, with emphasis on the MBSB, Treasury bonds, BTFP, RRP, and TGA
The size and the composition of the Federal Reserve’s assets determine the market liquidity. The recent balance sheet trends indicate the total assets of the Federal Reserve, reflecting its monetary policy decisions. RRP or reverse repos, are transactions where the Federal Reserve temporarily drains liquidity from the financial system. The contraction of the money supply through RRP operations can pose risks to bonds and tighten financial conditions. Refilling the TGA, in combination with the Fed’s Quantitative Tightening (QT), contributes to reducing liquidity.
The First Stage (23.06.2023-23.10.2023) - Following the U.S. government's debt ceiling increase, the Treasury General Account (TGA) was replenished, reaching $750 billion by 15.10.2023. The Treasury's preference for issuing short-term bonds contributed to the inversion of the Treasury yield curve. Although the Reverse Repurchase Agreements (RRP) absorbed a significant portion of short-term debt, the Federal Reserve's Quantitative Tightening (QT) persisted, sustaining overall tight market liquidity. During Q3, both the U.S. dollar index and bond yields experienced an upward trend.
The Second Stage (23.10-2023 - ???) - Post-TGA replenishment, there was a balanced release that facilitated fiscal investment and credit expansion. Simultaneously, the acceleration of declining Reverse Repurchase Agreements (RRP) contributed to liquidity release, offsetting the impact of Federal Reserve Quantitative Tightening (Fed QT) and injecting ample liquidity. In Q4, U.S. stocks experienced an upward trend, while the U.S. dollar index and bond yields trended downward.
The Third State (RRP Scale change) - The upcoming reduction in the RRP scale may significantly influence risk and liquidity preferences. If the RRP scale decreases sharply by March 2024, Fed QT will directly consume bank reserves, impacting Treasury bonds and overall bank liquidity.
The logic is Fed QT involves selling assets held by the Fed. The banks need to buy those assets held by the Fed. The reduction in bank reserves affects the capacity of banks to hold assets such as Treasury bonds. This can put downward pressure on bond prices and potentially affect the overall bank liquidity.
In addition, the BTFP, introduced after the SVB incident, is set to expire on March 12, 2024. With U.S Treasury yields peaking, the BTFP size surged to $144.8 billion.
This is why Dallas Fed President Logan emphasizes the Fed should shift to liquidity concerns rather than interest rates.
The Treasury Department initiatives a buyback program to manage liquidity and cash.
The program involves 2 bond types:
Nominal Interest Rate bonds, spanning 7 maturity ranges, with repurchase capped at $28 billion/quarter across different maturities.
Inflation compensation bonds (TIPS), also in various maturity ranges, with a maximum repurchase scale of $2 billion/quarter.
Repurchase caps are tailored based on tradable volume and maturity, occurring 1-2 times per quarter for liquidity support and around tax days for cash management.
Four non-repurchase categories include delivery bonds of Treasury bond futures, high premium bonds, bonds with smaller issuances, and new or "sub-new bonds" to prevent large cash inflows nearing tax dates.
Notably, the program extends to U.S. Treasury bonds held by the Federal Reserve System Open Market Account (SOMA), adding complexity to the repurchase landscape.
References
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
https://www.dallasfed.org/news/speeches/logan/2024/lkl240106
https://fred.stlouisfed.org/series/RRPONTSYD#
https://www.linkedin.com/posts/f%C3%A1bio-santos-00728a100_monday-macro-mechanics-ive-taken-a-moment-activity-7134915354312482816-Jv3T
https://bb-economy.com/repo/
https://www.federalreserve.gov/releases/h41/current/h41.htm