The Federal Reserve’s (Fed) interest on excess reserves (IOER) shot to prominence last month following an unprecedented adjustment by the central bank. What was the rationale for the change and what, if any, are the implications for markets and investors?
The evolution of Fed monetary policy
Depositary institutions hold required and excess reserves on deposit at the Fed. They are allowed to borrow and lend their excess reserves to ensure they meet their required reserve obligations. The effective fed funds rate (EFFR) is the volume-weighted, daily traded rate of all this activity (Exhibit 1a). It is actually a market driven rate, but influenced by the Fed to ensure it remains close to the fed funds target rate (FFTR).
Historically the Fed regulated interest rates by controlling the money supply via its open market operations (OMO) – either selling treasuries to drain market liquidity and pushed interest rates up, or buying treasuries to inject market liquidity and pushed interest rates down. However, during the global financial crisis, the Fed’s quantitative easing program injected a massive amount of liquidity into the banking system, effectively removing the structural short in fed funds and boosting excess reserves (Exhibit 1b). The need for banks to trade fed funds declined sharply and the effectiveness of OMO was significantly reduced.
In response to substantially lower fed fund trading activity, the Fed introduced two new monetary policy tools, interest on excess reserves (IOER) and the overnight reverse repo program (ON-RRP); the former acting as a ceiling – banks will not invest elsewhere at a lower rate, while the latter acts as a floor – banks must pay at least this rate to attract deposits. Since the Fed began raising rates in December 2015, it has increased its target rate, IOER and RRP in tandem and by the same amounts.
The Fed’s interest rate challenge:
Recently the Fed’s monetary policy model has shown signs of stress as the EFFR moved towards the top of the Fed’s target trading range and the EFFR/IOER spread narrowed to post-global financial crisis lows (Exhibit 2a). During his latest testimony, Chairman Powell expressed uncertainty about the reasons for the EFFR movement; exacerbating market concerns about rising funding costs, tighter liquidity conditions (Exhibit 2b) and the impact of the Fed’s balance sheet reduction.
Nevertheless, to ensure that EFFR continues to trade within its target range, the Fed took the creative and expedient step of raising the IOER by 20bps while raising other rates by the customary 25bps at the Fed open market committee meeting in June. This unusual adjustment provides a strong signal of the Fed’s intention to prevent the EFFR breaching the IOER ceiling.
IOER – much ado about nothing?
In reality, EFFR breaching IOER or the Fed target range should have no major technical or operational implications; however, many market participants would view such an event negatively and question the Fed’s ability to control a historically important benchmark rate.
For now, it appears that the Fed’s “technical” IOER adjustment has achieved its goal of moving the EFFR back towards the mid-point of the target range. However, the continued challenges of increased Treasury bill issuance, tax repatriation and the Fed’s balance sheet reduction suggests the problem may re-emerge, and with the Fed’s credibility on the line, it is now important for investors to monitor EFFR movements. Any further erratic deviations will trigger additional Fed actions – which could range from another adjustment of the IOER to something potentially more drastic, such as an early end to the Fed’s balance sheet reduction program (which would have major market implications).
For US$ cash investors, a hawkish Fed and tighter funding are significant positives, pushing interest rates higher and boosting returns on cash investments. With real rates (Fed Funds Target Rate – Core CPI) approaching their highest level in almost a decade and commercial paper offering significant yield pickup over treasuries, cash investments have re-emerged as an important asset allocation choice.
On last Sunday, July 1, Mexico held its largest ever election as over 56 million voters turned out to elect a new president, congress, and over 3,400 positions across all levels of government. Former mayor of Mexico City, Andrés Manuel López Obrador, commonly known as AMLO, won by a landslide, securing 53% of the vote and a 31-point margin versus the second place candidate. While polls had given AMLO a sizeable advantage, the scale of his victory translated to a larger than expected showing in the popular vote and a majority for his coalition in both houses of congress.
In many ways, this year’s election marked a significant shift in Mexico’s political, social and economic history. This year’s election was AMLOs third run for president. In his first run in 2006, AMLO lost by a miniscule margin of <0.6% in the late hours of counting, and then disputed the results by hosting his own “alternative inauguration” in the Zócalo, Mexico City’s historic city center. This image of a scorned and raving man, coupled with some of his more populist ideologies, left many market participants nervous about his return to power.
Yet it was precisely some of these characteristics that led AMLO to victory this year when many Mexican voters wanted change above all else. Following his loss in the 2012 election, AMLO established a new left-leaning party smartly named Movimiento Regeneración Nacional, or “MORENA”, which is Spanish for “brown woman”. The new party became incredibly well-positioned to earn votes from a Mexican public frustrated by a century of rule under establishment parties that seemed only to result in rising inequality, insecurity, and corruption.
Despite the historic nature of these elections and the outcome – the market reaction has actually played out in a somewhat repetitive fashion. Looking specifically at the currency, the Mexican peso (MXN) started depreciating around two months before the election, but then started recovering a couple weeks right before the election and has now completely recovered back to its 200-day moving average.
Part of the recovery could be attributed to the market-friendly message AMLO has projected since winning – he has emphasized more policy continuity, especially in the areas of fiscal discipline, central bank independence, and NAFTA negotiations. However, he has also so far remained committed to some of his more concerning policy proposals – a review of the massive and well-underway Mexico City Airport project, a review and pause in oil-field auctions which were a key component of Mexico’s landmark energy reform, a plan to build additional and likely unprofitable refineries, and additional social benefits for the youth and elderly to be financed from yet undetermined sources. Market participants will need to follow how these policy proposals develop, but for now, markets and AMLO are both enjoying a honeymoon period before his inauguration on December 1.
After December 1, the medium-term story remains more uncertain as AMLO reconciles campaign promises with reality. However, as a country with the most liquid emerging market currency and a large majority of domestic government debt held by foreigners, market discipline will remain a big hurdle for significantly unfriendly policy shifts. While markets may not yet love AMLO, they have certainly learned to live with AMLO for now.