Wall Street Ponders the Fed's Choice to Modify Key Instrument -

The Federal Reserve is expected to lower the rate on one of its tools used to manage the primary policy benchmark. However, some participants on Wall Street are questioning the rationale behind this possible adjustment.

Most strategists predict that the Fed will cut the offering rate on its overnight reverse repo facility (RRP) by 5 basis points, potentially as early as next week, in line with projections of a quarter-point reduction to the benchmark rate. The current RRP rate is at 4.55%, which is five basis points above the lower boundary of the Fed’s target range of 4.5% to 4.75%.

These forecasts arise after officials suggested they see the merit in a “technical adjustment” to the RRP rate, aligning it with the lower bound of the federal funds target range, as highlighted in the minutes from the November meeting. While such a modification could place downward pressure on money market rates, it may also affect the volume of funds held at the Fed facility, spurring discussions on Wall Street about the potential benefits of this change.

Since reaching their peak in December 2022, balances at the facility—a gauge of excess liquidity within the financial system—have declined by about $2.4 trillion, though the pace of this decline has recently slowed. On Wall Street, the total cash parked at the RRP has been regarded as a crucial indicator as the central bank continues to shrink its balance sheet in a process known as quantitative tightening.

Barclays Plc views the alignment of the RRP with the lower limit as a “purely technical” adjustment based on insights from the meeting minutes. However, firms like Bank of America, TD Securities, and Citigroup express confusion regarding the need for such a policy change now, especially with about $175 billion currently allocated to the RRP. Furthermore, usage is expected to grow naturally in the first half of 2025 due to anticipated reductions in the Treasury bill supply stemming from the debt ceiling, possibly leading counterparties to deposit more cash at the RRP.

The last modification in the tools occurred in June 2021 when the rate on the RRP facility was increased to counter an oversupply of dollars in short-term funding markets that greatly surpassed the availability of investable securities, thus exerting downward pressure on front-end rates, even while the Fed’s primary benchmark remained stable. At that time, $521 billion was held in the overnight RRP facility.

Expert Insights

Wrightson ICAP (Lou Crandall, December 9 report)

Wrightson now anticipates that the Fed will reduce the RRP rate by 5 basis points either next week or during the January meeting, despite Crandall’s earlier assessment that such an adjustment was “likely still some months away.”
The timing of the adjustment may depend on the Fed’s upcoming policy decisions, as the central bank might choose to decouple the rate cut from the technical adjustment.
They do not expect significant ripple effects on unsecured rates, mainly because the fed funds market primarily reflects overnight cash that Federal Home Loan Banks temporarily deposit at foreign institutions for liquidity purposes. The arbitrage spread has remained stable at 7 basis points for most of the last three years, and a continued spread between fed funds and interest on reserve balances is anticipated.
The firm forecasts that both the Secured Overnight Financing Rate and Tri-Party General Collateral Rate will decrease by 4 basis points relative to the Fed’s target range but acknowledges a possible full pass-through of 5 basis points.

Morgan Stanley (Martin Tobias, December 6 report)

Analysts predict a 5 basis point reduction in the RRP rate at the December meeting, viewing the adjustment as a means to realign the rate with the lower bound of the federal funds target range that established the facility as a monetary policy tool.
The mention of a technical adjustment in the November FOMC minutes, along with a staff briefing on balance-sheet management, suggests that quantitative tightening and the operation of money markets are high on the agenda.
It is expected that the fed funds rate will remain 8 basis points above the lower bound—currently at 4.5%—as it seems unlikely that fed funds volumes will increase sufficiently to exert downward pressure.

Citigroup (Jason Williams, December 6 report)

Determining when the Fed might enact an RRP adjustment is complex, as assessing the need for it is challenging, according to Williams. The Fed may not feel the need to adjust the RRP rate until the January meeting (or even later into 2025), especially if the debt ceiling is a primary concern.
If the market had expected a December implementation, the SOFR/fed funds Dec/Jan futures curve would have steepened more noticeably. This would impact roughly 10 days this month and about 25 days in January; the futures curve should have steepened by 0.4 basis points for each 1 basis point shift in SOFR/fed funds, but this steepening did not happen.
Whenever the Fed decides to reduce the RRP rate by 5 basis points, tri-party repo rates are expected to decline by the same margin, along with bilateral rates, although a move of only 3 to 4 basis points may occur as dealers might take an extra basis point or two. Fed funds are expected to continue trading 7 basis points below the interest on reserve balances (IORB) rate.

Bank of America (Mark Cabana, December 5 remarks)

There is no strong certainty that the Fed will modify the RRP rate in December — although it appears likely — as “the rationale behind the move is quite puzzling to us,” Cabana noted during a press briefing discussing BofA’s 2025 outlook.
If the Fed proceeds with a 5 basis point adjustment to the RRP rate, it will subsequently lower repo and T-bill rates, with the Secured Overnight Financing Rate also decreasing by the same amount.

JPMorgan Chase & Co. (Teresa Ho, Srini Ramaswamy, December 2 remarks)

“A reduction of the RRP rate by five basis points will effectively shift SOFR back into the middle of the target range,” Ho commented during a media roundtable focused on its 2025 forecast.
“It might be that lowering RRP rates won’t have much impact given the low balances at the RRP, but a decrease in IORB could be advantageous,” Ramaswamy added.

TD Securities (Gennadiy Goldberg, December 2 report)

The Fed’s inclination to lower the offering rate on the RRP facility—possibly in December—might provide the central bank with a strategy to stave off reserve shortfalls “for a while longer.”
The firm still expects that the Fed will completely halt its QT by March 2025, viewing the RRP adjustment as a temporary measure.
A 5 basis point reduction in the RRP rate is anticipated, while interest on reserve balances will likely remain steady, leading to a 5 basis point decline in SOFR and about a 4 basis point decrease in the fed funds rate; read more

Deutsche Bank (Steven Zeng, Matthew Raskin, Brian Lu, December 2 report)

The imminent adjustment, likely in December, aims to achieve two goals: alleviating upward pressure on money market rates and continuing to reduce RRP balances.
Repo rates are expected to decrease following the adjustment, with a “partial” pass-through to the effective rate on fed funds anticipated.

Barclays (Joseph Abate, Nov. 27 report)

“The reasoning behind decreasing the RRP rate is strictly technical,” Abate stated. “It aims to restore the rate to its pre-pandemic level at the lower edge of the fed funds band.”
The Fed is expected to maintain the interest on reserve balances (IORB) rate at 4.65%, widening the gap between the two rates to 15 basis points.
In general, a 5 basis point reduction in the RRP rate is projected to lower all repo rates similarly, though it’s important to note that this reduction will not change market fundamentals, given that balance sheet capacity remains constrained and the demand for funding across all assets stays strong; read more

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