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Time to Pay Back the Fed

Written By Briton Ryle

Posted September 17, 2014

We all knew the time would come, and it’s almost here. When the U.S. Federal Reserve started pumping money into the economy in the wake of the 2008-09 financial crisis through two cash infusions (Quantitative Easing 1 and 2) and over $1 trillion of monthly bond and mortgage purchases (QE 3), everyone knew that at some point all this free money would be taken back out of the system.hundred dollar bills cash

Analysts believe that time will soon be upon us. In fact, the Federal Reserve has already been testing its process for taking its money back.

“The Fed has been testing overnight reverse repos with a limited set of counterparties, mostly money funds, as a tool to set a floor under short-term interest rates when it begins guiding those rates higher, an event Fed officials forecast to occur in 2015,” Bloomberg informs.

“Some 61 percent of 43 economists in the survey said the Fed would have to borrow more than $250 billion per day on average through its overnight reverse repo facility to sustain a floor under the federal funds rate at liftoff.”

Wow! There is much info packed into that last paragraph that we are going to have to back this up a bit to get a sense of what it means to us as ordinary investors and home buyers.

Let’s see what all that mumbo-jumbo is about.

The Fed Giveth

Do you recall what the single biggest problem caused by the 2008 financial crisis was? An evaporation of liquidity. Banks had purchased mortgage-based securities (stocks in funds that used mortgages as assets) which suddenly turned nearly worthless when tens of thousands of mortgages defaulted. As wealth evaporated, banks were left holding worthless paper, driving many of them into bankruptcy or close to it.

As banks lost their money, they stopped lending almost completely, which seized the gears of the economy. Businesses started failing, and jobs were being lost.

The solution? Reduce interest rates and fill the banks up with emergency cash. With money in their vaults again, banks could resume lending, and at cheaper rates. The availability of money at a cheaper cost allowed businesses to borrow again and rehire workers. It also allowed home buyers to purchase properties again, slowly repairing the damage to property values.

The first part of the solution was easy enough; the Fed lowered interest rates simply by lowering the benchmark interest rate it charges banks.

But the second part – infusing banks with liquidity – was a little tougher. The Fed couldn’t simply give the money away for free, so it agreed to buy mortgages packaged as securities, or mortgage-backed securities, from the banks. This gave cash back to the banks which they could use to issue more loans and mortgages, spurring business expansion, hiring, and home buying.

Yet at some point the banks would have to buy back all these mortgage-backed securities from the Fed and give the central bank its money back. This was no free lunch.

For the banks, the process of buying mortgages back from the Fed and giving cash back to the Fed is known as a repo, or “repurchasing agreement”. For the Fed, the process of selling mortgages back to the banks and getting its money back is known as a “reverse repo”.

With QE 3 now almost completely wound down to zero, the Fed will soon stop purchasing mortgage-back securities from the banks. The next step after that is the raising of interest rates, likely beginning in late 2015 or early 2016.

Yet when interest rates finally begin rising, the Fed will also have to begin removing money back out of the system through reverse repos – selling mortgage-back securities back to the banks. The two go hand-in-hand, rate hikes with the removal of cash from the system. Why?

The Fed Taketh Away

Because too much extra cash circulating throughout the economy undermines any interest rate hikes. Think of driving a car, where raising interest rates are like applying the brake while having a lot of cash in the system is like applying the gas. If you hit the brake with your left foot while still applying gas with your right foot, you are undermining your own attempt at slowing down your car.

As Bloomberg explains, “In order to raise bank borrowing costs and ensure that the fed funds [interest] rate doesn’t trade below the FOMC’s target range when it begins [raising rates], the Fed will have to absorb cash … lent to banks.”

Millan Mulraine, deputy head of U.S. research and strategy at TD Securities USA LLC in New York anticipates that “for the Fed to be able to engineer policy tightening, it would probably have to absorb a significant portion” of the liquidity it injected into the banking system through its monthly purchases.

OK, so any rise in interest rates must be accompanied by a removal of some cash liquidity out of the system. If the Fed does not remove cash from the system, then the Fed would have to apply the brakes harder in order to the slow the vehicle down, raising interest rates higher and faster – something which the economy cannot support.

Thus, if the Fed wants to apply a little braking with the left foot by raising interest rates just a little, it must also ease up on the gas with the right foot by removing some cash out of the system.

Only we have a problem here: the Basel 3 agreement which requires banks to have a certain amount of cash reserves is not yet fulfilled. Banks are not quite fully capitalized, and aren’t strong enough to return any cash back to the Fed.

The Fed has to find a way of removing cash from the system without permanently taking it away from the banks.

The solution?

Reserve Repos for Rent

Instead of selling mortgage-backed securities back to the banks, the Fed will merely rent them to the banks. The end result is that instead of permanently returning cash to the Fed, the banks will simply be lending cash to the Fed temporarily.

For the banks it’s a win-win scenario. First, the banks get to keep the cash they owe to the Fed. Second, by lending cash to the Fed, the banks will collect interest from the Fed. This interest from the Fed to the banks is pretty much another stimulus arrangement of sorts.

But won’t the banks still feel the absence of all that cash? No. “In an overnight reverse repo, the Fed borrows cash from counterparties using securities as collateral. The next day, it returns the cash plus interest to the lender and gets the securities back,” Bloomberg explains.

Thus, the Fed will borrow the cash overnight when the banks aren’t using it. Immediately the following morning, the Fed returns the cash back to the banks, with interest.

This is why the amounts borrowed are so high. “The Fed would have to borrow more than $250 billion per day on average through its overnight reverse repo facility to sustain a floor under the federal funds rate”, Bloomberg explained as noted at the outset.

In a trial run so far, this rental reverse repo seems to be working. “So far, tests show the tool has been effective: a key measure of repo market rates calculated by the Depository Trust and Clearing Corporation hasn’t traded below the Fed’s overnight reverse repo rate since Feb. 26, when the New York Fed increased it to 0.05 percent,” Bloomberg reports.

Thus, the Fed is able to prop-up slightly higher interest rates when they finally begin rising without having to permanently remove liquidity out of the system.

What it Means for You

So what does all of this mean for the average investor and home buyer? Well, to be honest, not much. What does matter is that higher interest rates are approaching, likely in late 2015 or early 2016. The way the Fed orchestrates them doesn’t really matter to us average folk.

All investors need to know is that on the initial rate hike – even two or three months before – stocks and bonds will take a little bit of a tumble, with bond yields rising to reflect the slightly more expensive cost of borrowing. Home buyers too will notice a change when they apply for mortgages, with higher rates being passed on to them. Small business owners will likewise notice higher rates when applying for loans.

If you foresee the need to borrow money in the near future, try to get that done now, while rates are still low. If you have stocks in your portfolio, keep your equities and cash at a reasonable ratio, perhaps 80% stocks and 20% cash, or even 70-30.

The time for excessive risk taking is almost over as normal volatility will soon be returning to the markets. But this does not mean the bull run is over, as the Fed is expected to stop raising rates when they reach 3.5% or so, perhaps by 2017-18. This bull run still has another 10 years to go, many economists expect. It’s just going to be accompanied by normal volatility, that’s all.

Joseph Cafariello