With an acknowledgment that economic activity has consistently strengthened since the third quarter, Fed Chairman Bernanke announced at the December Federal Open Market Committee (FOMC) meeting that the Federal Reserve would begin to reduce emergency quantitative easing commencing in January. Moreover, he said the FOMC expects quantitative easing to be fully concluded by the end of 2014. While we are cheered to see the Fed retreat from what we deem to be irresponsible monetary policy, we see the measure as only a small step in the right direction. While not apparent to those unfamiliar with the mechanics of the money markets, that marketplace is not operating as smoothly as it should and that’s directly attributable to QE. Banks have not been able to lend and invest the $85 billion of freshly printed cash the Fed generates every month. As a result, cash is flooding into the money market resulting in a shortage of Treasury Bills and money market instruments. In the last week of 2013, the shortage became so acute that Treasury Bills were trading above their par maturity price, resulting in a negative yield for buyers. On the 31st of December, the Federal Reserve satisfied the Bill shortage with their Fixed Interest Rate Reverse Repo facility, which is their de facto deposit facility. The facility is open to 139 counterparties including 94 mutual funds, the various government-sponsored enterprises, 21 primary dealers and the largest commercial banks. The amount “deposited” at the Fed was an astounding $197.8 billion. While it’s not unusual for interest rates to vacillate wildly at year-end as supply and demand for excess cash comes into equilibrium, such an amount is extraordinary. Transaction volume in the facility remained elevated well into the New Year, with $60 billion trading on January 13th. That represents an enormous amount of excess liquidity, and likely a consideration in the FOMC’s decision to reduce the pace of QE. As an aside, the Fixed Rate Reverse Repo is an arcane policy tool that, while not new, has been increasingly mentioned in the media. We suspect that as the Federal Reserve ultimately moves to raise interest rates, the Fixed Rate Reverse Repo will be a more closely watched measure.
Since the announcement, rhetoric from the various Fed Presidents and Governors has taken a decidedly hawkish tone. As we’ve speculated for some time, the change in Fed policy will occur in incremental steps, carried out through public debate via the media. Since the taper announcement, that debate has intensified and the collective voice of the Fed has changed from nearly unanimous dovishness to a more conciliatory tone in which the majority are in agreement that less aggressive stimulus is desirable. The most glaring change is evident in the “jaw-dropping” statement made by New York Fed President, and easy money advocate, Bill Dudley. In a speech delivered to the American Economics Association on January 4th, he remarked that “We don’t understand fully how large-scale asset purchase programs work to ease financial conditions…”. After nearly $4 trillion dollars of money printing and interest rate manipulation one of the most ardent advocates of quantitative easing declares that he’s not sure he understands how the program works. That certainly doesn’t engender confidence in our Central Bank!
Despite the pledge to taper, investors continue to believe that the first rate hike is still far off, as is evident in the muted movement in short term interest rates compared to longer maturities. As we’ve described on numerous occasions, a pillar of the Halyard investment thesis is that short term interest rate options are too cheap and will rise in price as the Fed moves to normalize interest rates. We continue to deem the position as offering a highly attractive reward/risk payoff and expect that as economic activity continues to grow at a robust pace, traders will begin to discount the Fed pledge to hold rates low and will push short-term interest rates higher.