EFF-IOER: What's Next?

Same as  Cackalack Capital, this is my first post. I joined the troops after MM asked for some help. I am honoured and thrilled to get the chance at it. Please feel free to contact me with any questions, comments, ideas at macrodiver1@gmail.com.

Alongside the wild ride in Libor-OIS, which was the subject of a Cackalack post, something on my radar and somewhat less discussed, apart from some short end nerds like myself, is the narrowing of the EFF-IOER spread ( Effective Fed Funds -Interest Rate on Excess Reserves) . 

For almost all of 2017 that spread was at 9 bp. Then coming into the FOMC December 2017 meeting it started to tighten. Of course this is moving at a snail pace but a move from 9 bp to 5 bp in about 4 months for something that didn’t move for 18 months prior to that is entitled to raise a few eyebrows. 

Some would say the Fed started shrinking its balance sheet in October last year and this is draining reserves, putting upward pressure on the Fed Funds rate. That's true but... In October excess reserves were 2.12 Tn, in December it was 2.19 Tn, so this explanation doesn't hold for the December move. It now stands at 1.99 Tn, it’s starting to bite and will more so in the future as the balance sheet reduction accelerates (see graph below). 

Another culprit could be the diminishing weight of the standard FDIC assessment charge but here again we are talking pennies. The weighted average was 4.4 bp in Q2 17, 4.2 bp in Q3 17, we don't have the numbers for Q4 yet but even tough banks capital improvement will drive it lower it's unlikely to be the catalyst.

What about Bills and Bonds issuance ? As we can see from the chart below, the Treasury cash balance started to move up in December and has been on an accelerating path since then. This is due to the large Bill issuance that started then and accelerated after the US budget was voted in early February. It is now sitting at 414 bios, over the Treasury projection of 360 bios for end of June, certainly aided by this month tax receipts inflows. 

The Bill issuance is also draining reserves and alongside the increasing Bond issuance it has an other side effect. It creates upside pressure on  GC overnight repo rates. As a proxy I'm using the GCF Index as longer history for SOFR and BGCR are not yet available. As we can see below the 5days moving average GCF - IOER spread has tightened from -7 to +1 in the last 2 months. A correlation with Tbill outstanding seems to exist.   This is changing the relationship between the various overnight rates and in my view is the main driver behind the move higher in Fed Funds.

This month the Treasury has slowed down Bill issuance due to the tax receipt inflows but they will ramp it up again in May.   The Fed has also increased the passive balance sheet reduction from 20 bios to 30 bios/month at the beginning of April (it will be 40 bios from July and 50 bios from October). This 2 factors let me believe the Effective Fed Funds Rate has not finished its march higher and we could see it getting nearer the IOER rate in the coming months.

Good luck,

MD