Given the upcoming FOMC meeting, it's worth revisiting some of the mechanics around the rate hike. The FOMC is fully expected to lift the Fed Funds target range by 25bp - from 0-25bp to 25-50bp.
The current Fed Funds rate is around 13bp. Does it mean that after the FOMC meeting we will see the rate at 38bp, exactly 25bp above the current level? A number of analysts don't think so. Here is why.
In theory banks lend to each other overnight at a rate that on average should equal to the Fed Funds rate. However interbank lending has declined sharply after the financial crisis as banks rely on other sources of financing.
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| Source: St Louis Fed |
A great deal of the overnight activity these days comes from the Federal Home Loan Banks (FHLBs) who often place their excess liquidity with commercial banks. They do this because they don't receive interest on reserves as private commercial banks do. Instead they place excess funds with commercial banks in order to receive some non-zero rate. That interbank rate however has to be some amount above the riskless overnight rate in order to make these transactions worthwhile for the FHLBs. That riskless rate in this case is based on the Fed's RRP (see post), with the latest auction setting at 5bp.
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| Source: NY Fed |
The current spread between Fed Funds and the RRP is about 8pb and some view this spread as remaining relatively constant immediately after the hike. The FHLBs' demand to place liquidity will keep the Fed Funds rate at the lower portion of its range but at this minimal spread (8bp) above the RRP rate.
This week the Fed will be taking the following action.
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| Source: Morgan Stanley |
With the RRP rate going up to 25bp and the spread to Fed Funds remaining constant, the new Fed Funds rate would move to 33bp. And that is 20bp (not 25bp) above the current level.
As a result of this projection, the calculation for the rate hike probability implied by the Fed Funds futures would need to change. Instead of being around 79% (chart below), which is based on the 25bp assumption, this week's rate hike probability is closer to 98% (based on the 20bp increase). The December 16th liftoff is now fully priced into the markets.
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| Source: CME |
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