Fed Funds Trading at Highest Level in a Year as Central Bank Increases Key Reverse Repo Rate

Currently, Federal funds are trading at the highest level in a year, this as the Central Bank increases a key reverse repo rate. To analysts, this suggests the tool will allow policy makers to lift borrowing costs eventually.

Fed funds, which is the US overnight rate used for borrowing and lending of cash between two banks, opened at 0.10% yesterday, hitting the highest level since January 7. According to data from ICAP Plc., this hit at 0.09% today. The effective rate, otherwise known as the volume weighted average associated with these transactions climbed to 0.11% on November 18, the most since October of last year after staying at 0.09% since July 1, excluding 11 days.

The rise in Fed funds that had previously held fast while other money market rates increased is being attributed to the Fed’s increase this week of the fixed rate offered at its reverse repo facility, according to analysts. The tool has been tested by the Central Bank, which drains cash overnight in an effort to put a foundation under short-term interest rates when it tightens monetary policy sometime in 2015.

As stated by Joseph Abate, money market strategist with New York-based Barclays Plc., there was a long period where Fed funds were flat lined with it seeming at its sensitivity to movements in other money market rates disappeared. Abate who is one of the 22 primary dealers acting as counter-parties in open-market operations with the Fed added that this week’s rise suggests when the reverse repo rate is moved by the Fed, it can influence Fed funds rate so in theory the Fed should have the ability to push the funds rate wherever they want it to go.

Needing a tool that will influence money market rates directly, the Central Banks market rates arose after nearly six years of bond buying used to stimulate economic growth flooded the banking system with excess reserves of close to $3 trillion. This eliminated the need for banks to borrow cash daily in the Fed funds market. However, it also diminished the funds rate as a sign of the true cost of overnight credit.

Pertaining to an overnight reverse report, cash was borrowed by the Fed from counter-parties who used securities as collateral. The following day, the lender gets paid back cash, as well as interest, but also gets the securities returned.

In a discussion among Fed staffers last month and according to October 28 and 29 Federal Open Market Committee meeting minutes released, changes in the overnight RRP rate would further provide information specific to the effectiveness of an ON RRP facility in its ability to provide a floor for money market rates during policy normalization.

The fixed rate on its program during the testing process was adjusted by the Fed but also announced a schedule for adjustments for the first time on October 29. Through November 28, the rate will stay at 0.07% but then climb 0.10% for the period of December 1 through December 12. Between November 3 and 14, the rate was at 0.03%. The Fed plans to provide details of a test on a term reverse repo agreement sometime next month.

Before this week, Fed funds were stable even while the rate for borrowing and lending Treasuries for one day in the repurchase agreement market swung from 0.018% to a high 0.198% since July 1. The repo rate for general collateral Treasure was 0.123% yesterday as shown in the Depository Trust and Clearing Corp. index.

Effective September 22, policy makers with Central Bank capped the size of overnight reverse repurchase facility at $300 billion a day, this after officials to include the New York Fed President William Dudley, showed concern about playing too big a role in the banking sector.

Peaking at quarter end periods was demand for the Fed’s reverse repo, while dealers’ balance sheet constraints caused private repo availability to drop. Investors placed $300 billion at 0% on September 30, which is set through a bidding process when a breach of the cap occurs. In the prior quarter end when no aggregative limit existed, total reverse repos totaled $339 billion with the average daily use in 2014 being $126 billion.

Officials with the Fed said that adjusting the interest rate paid on excess reserves and currently at 0.25% would be the main tool used to increase Fed funds rate when it is right to tighten monetary conditions. The reverse repo facility will help keep the Fed rate close to the target range set by the Fed.

In Fed funds on November 18, the low trading was at 0.07%, representing the highest level for the base of daily trading range yet this year. High for the funds over the past two days was at 0.3125% while the low of 0.04% was reported yesterday.

Ira Jersey, interest rate strategist at Credit Suisse Group in New York stated that these tests appear to prove that the Fed’s reverse repo program is working. Since the Fed can drain only a few hundred billion in reserves through the facility, with the exception of quarter ends, the program can act as an effective floor for rates. Enough transactions are being carried out to influence rates the way the Fed thought.

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