With all the focus on the shape of the U.S. yield curve recently, fixed-income traders could be forgiven for not concentrating so much on the growing tumult in the fed funds rate.
Not anymore.
Rising money-market rates have forced Federal Reserve officials to take unprecedented steps to maintain control over their key policy benchmark -- and the job is about to get harder. With the Treasury continuing to ramp up bill issuance and the central bank’s balance sheet unwind accelerating, the front-end is poised to take center stage in the second half of the year.
From further policy-tool adjustments, to the outlook for balance-sheet normalization, to America’s debt-management policies, the influence of short-term rates is set to reverberate through the financial system. It’s forcing traders to focus on funding markets once again, just months after Libor’s surge brought the usually sleepy corner of the fixed-income world roaring to the fore.
“The fed funds rate is starting to become exciting,” said Gennadiy Goldberg, a strategist at TD Securities in New York. “The money-market space is going to be squeezing the fed funds rate higher, and then you have the Fed balance sheet” runoff ramping up.
While many Fed officials have publicly expressed their angst about a possible inversion of the yield curve -- and what that would signal -- trouble in the money markets is also clearly on their minds.
Last month, in an effort to maintain control of an effective rate that climbed to within just five basis points of their target band’s ceiling, policy makers took the unprecedented step of reducing how much they pay on excess reserves that deposit banks keep at the Fed (the IOER rate) relative to the upper bound of the range.
Chairman Jerome Powell, at the conclusion of the Federal Open Market Committee’s June policy meeting, acknowledged that a burst in bill issuance to plug swelling budget deficits was likely at least partly to blame for fed funds becoming unhinged.
The surge in supply pushed key overnight rates higher, especially in the market for repurchase agreements. As these other short-term assets became more attractive alternatives to lending reserves to other banks, the availability of interbank funding lessened, putting upward pressure on the policy rate.
As the second half of the year gets underway, T-bill supply is poised to expand by another $290 billion, according to JPMorgan Chase & Co. estimates. Deutsche Bank AG expects an additional $185 billion of net bill sales, most of it arriving in the fourth quarter. That’s after about $200 billion of net issuance in the first six months of 2018.