MNI EXCLUSIVE: US Fiscal Push Could Prompt Year-End IOER Rise

The U.S. government's gusher of T-bill sales should keep upward pressure on the fed funds market in coming months, but future Congressional stimulus could draw down on the Treasury's swollen cash balance, potentially prompting the Federal Reserve to nudge up its Interest on Excess Reserves to keep rates within its target range, ex-officials told MNI.

The pandemic so far has led to a much greater increase in short-term Treasury securities than in bank reserves, causing upward pressure on the fed funds rate relative to the Interest On Excess Reserves rate, a force which should persist for months, former New York Fed research director James McAndrews told MNI.

"The federal funds rate, the Eurodollar rate, the overnight commercial paper rate cannot be explained well solely by the amount of reserves in the system under our current regime," McAndrews said. "It is not at all clear what changes might be required," especially when the Fed is already buying USD80 billion in Treasuries per month, adding to the pool of reserves, he said.

Todd Keister of Rutgers University, a former New York Fed economist, said the Fed is likely comfortable with the federal funds effective rate currently at 9bps, although "the Fed has at times been a little more sensitive to small movements than expected."

The Fed can use IOER to make sure the fed funds rate stays clearly within its target range. Even small changes in fed funds are closely tracked to make sure monetary policy is set correctly for the big volumes of short-term loans that can guide the rest of the market.

ADDITIONAL STIMULUS

But upward pressure on fed funds could swing the other way should Congress agree on stimulus, said Jon Hill of BMO Capital Markets and a former debt manager at the Treasury Department. "It makes sense for the Fed to be in a wait-and-see posture on IOER until we have clarity on the path of stimulus and bill issuance," he said.

Fed funds has been high relative to IOER, Hill said, but there is a "downward bias" going to the end of the year with QE and a possible stimulus. "If we see the [Treasury General Account] come back down you'll see rates fall pretty meaningfully" by about 5bps, raising the chances for a IOER hike.

McAndrews estimates that a trillion dollars of additional bank reserves reduces the fed funds rate by 8bps relative to the IOER. An additional trillion dollars of Treasuries with less than a year to maturity tends to increase it by about 3bps.

The surge in the value of outstanding short-term Treasury debt is the dominant force now and seen as likely to continue in the near-term, with issuance of USD8.9 trillion in bills since March and USD2.4 trillion in net new bills from April to August. That more than compensated for the rise in bank reserves from USD1.9 trillion to USD2.9 trillion.

The flip side of this year's record Treasury bill sales is a hoard of cash now in limbo as Congressional talks over another fiscal package flounder. Treasury has been left holding more than twice as much cash than it had expected, at USD1.62 trillion as of Sept. 4. That rise is also due to lower-than-expected use of emergency Fed facilities, and a slow pace of small business loan-forgiveness for the Paycheck Protection Program.

UNCERTAINTY

With cash on hand, the Treasury could also create overnight market fluctuations by cutting down debt sales. Treasury earlier had projected USD2.2 trillion in additional borrowing in the second half of 2020 assuming a USD1 trillion stimulus. And an influx of quarterly tax payments on Sept. 15 could further alter its calculations of its financing needs.

"As uncertainty persists, we can count on a general account being bigger than it would be normally," said former Fed economist Roberto Perli now at Cornerstone Macro. "Shorter rates will be a little higher than they would have been otherwise."

"When you issue a quarterly refunding statement you tend to stick to it and you borrow no matter what. If it doesn't materialize then you deal with it in the next quarterly period," Perli said.

It is "prudent" that Treasury is holding an elevated cash balance, said Hill, the former Treasury debt management official, and "the bar to deviate from the quarterly refunding statement is extremely high."