Liquidity management and the Fed; BOJ decision preview
Tightness in the USD funding markets got acute over the past twenty-four hours, prompting the Fed to embark on repo operations (USD 75bn) to cap further increases in short-term rates. This episode highlights the difficulty of managing liquidity at a time when excess reserves are supposed to be abundant. Regulatory needs, bloated dealer balance sheets, sizable issuances, and seasonal factors combined to push the overnight GC repo rate to 3.93%. Typically, this rate hovers in between the Fed funds upper and lower bound (currently 2.00-2.25%).
The Fed needs a more permanent solution to cap these unwanted spikes in funding costs. There are several ways that this can be done – periodic injection of liquidity (similar to last night), quantitative easing (increase the amount of reserves/cash in the system), tweaking the IOER and the setting up of a standing repo facility. We think that a standing facility makes the most sense. It would avoid the need to estimate the timing and size of liquidity needed. Theoretically, this should have a stabilizing impact on all overnight USD rates including the SOFR, which is set to be the benchmark risk free rate when Libor expires n 2021. We suspect that the Fed will address funding concerns at the FOMC meeting and may announce that the facility (which has been mooted for several months) may be made available in the coming few months.
BOJ to hold fire for now
The Bank of Japan is expected to stand pat tomorrow while provide more clues about the timing and details of policy easing ahead. The current economic and financial market conditions don’t require immediate policy easing. Output growth has slowed but remained solid (July IP: 1.3% MoM sa). Inflation has slipped but remained positive (July CPI: 0.6% YoY). The 10Y JGB yield has fallen below the official target of ±0.2% since early-August (before rebounding in the past one week), obliging the BOJ to reduce the size of bond purchases during the regular operations this month. The USD/JPY has risen to 108 from the August bottom of 105, thanks to the thaw in China-US trade war and the recovery in global risk sentiment. The reaction of the yen to the ECB’s bazooka easing last week and global oil price spike this week has been mild.
The BOJ should find it necessary to mull measures to cope with the risks of further economic slowdown and renewed yen appreciation ahead. This considers the upcoming consumption tax hike, sluggish global trade conditions, and volatile geopolitical environment. The latest news that the US and Japan have reached an initial trade agreement does not provide much relief. The agreement mainly covers tariff reductions on agricultural and industrial goods. Whether Trump will not impose the threatened tariffs on Japanese autos remains unclear.
Policymakers may also want to brainstorm how to minimize the side effects of additional easing. Further cutting the policy balance rate (current:-0.1%) or widening the yield target band (current:±0.2%) could cause further declines in the long-term yields and exacerbate the pressure on banks’ profits. Some form of mitigating measures would be required, such as offering negative lending rates to banks, reducing the portion of banks’ reserves subject to negative deposit rates, among others.
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