(Adds Treasury expected to issue anywhere from $100 billion to $200 billion beginning in August)
By Jennifer Ablan
July 30 (Reuters) - Even if the Federal Reserve cuts benchmark interest rates this week for the first time in more than a decade, as is widely expected, U.S. money market strains will persist, Bill Campbell, co-portfolio manager of the DoubleLine Global Bond Fund, said on Tuesday.
“Ultimately, increased federal deficits and expanded Treasury issuance to fund those deficits, combined with a reversal in investor appetite for that growing supply of Treasuries, will bring pressures back into money markets,” Campbell said in a research report. “These markets are already taut due to the quantitative tightening done so far and increased regulation since the global financial crisis.”
Currently, the U.S. central bank rolls off billions of dollars of maturing bonds from its balance sheet each month without reinvesting the proceeds. That balance-sheet reduction - known as quantitative tightening (QT) - has, since October 2017, reduced what had been $4.25 trillion of bond holdings accumulated by the Fed between 2008 and 2014 to around $3.62 trillion now. QT is currently set to end in September.
Money markets serve as a key part of the Federal Reserve “monetary transmission mechanism,” starting with the effective, or average, federal funds rate, Campbell said in the report, titled “Quantitative Tightening Risks Decoupling Money Markets from Fed Funds Rate.”
“In normal conditions, the fed funds rate would exert a kind of benign domino effect on rates throughout the broader money markets and ultimately into the capital markets.”
However, to the extent that QT heightens volatility in the money markets, it counteracts the “downstream effect” of the fed funds rate on rates in other money markets, he said.
Complicating matters, Campbell said, is an upcoming change to the one short-rate benchmark underlying almost every floating-rate fixed-income instrument employed today, including adjustable-rate mortgages.
The London Interbank Offer Rate (LIBOR), the interest rate currently used for all floating-rate securities, is due to be replaced by the Secured Overnight Financing Rate (SOFR). LIBOR is calculated by a bank survey, which has been criticized as failing to reflect true market rates as it rarely exhibits large spikes. In contrast, SOFR represents a weighted average of several different money-market rates.
“Those markets have been exhibiting large spikes,” Campbell said. “Thus, the shift from LIBOR to SOFR will compound the increased volatility in the money markets already resulting from QT.”
President Donald Trump and U.S. congressional leaders reached a deal last week on a two-year extension of the debt limit and federal spending caps that would avert a feared government default later this year but add to rising deficits.
The Treasury is expected to issue anywhere from $100 billion to $200 billion beginning in August in an effort to increase federal cash holdings to $350 billion at the end of September, which will increase the probability of a spike in money market rates and add to volatility. (Reporting by Jennifer Ablan in New York Editing by Matthew Lewis and Sonya Hepinstall)