December 14, 2007 / 9:13 PM / 10 years ago

FED FOCUS-New Fed term auction to draw good demand next week

NEW YORK, Dec 14 (Reuters) - The U.S. Federal Reserve’s first auction of new term loans on Monday is expected to draw good demand from banks, but may take time to deliver on the Fed’s goal of lowering short-term lending rates.

The U.S. central bank set up the new facility as part of a joint response by the Fed, the European Central Bank, and the British, Canadian, and Swiss central banks on Wednesday to ease liquidity and credit concerns in medium term money market.

Some interbank lending rates have fallen in the wake of Wednesday’s announcement, although they still remain above historical levels on concerns about banks’ capital and liquidity after many suffered large losses in the U.S. mortgage market this year.

“There is a positive feeling in the marketplace about the auction,” said Deborah Cunningham, chief investment officer at Federated Investors in Pittsburgh, Penn.

The Fed hopes banks will be encouraged to bid for the loans as they may offer potentially lower borrowing costs than the interbank market and the auction facility should have the stigma associated with borrowing the Fed’s discount window.

The minimum bid rate for the $20 billion 28-day loan was set at 4.17 percent, much lower than rates at the Fed’s discount window which are currently set at 4.75 percent after the Fed cut its federal funds target and discount rate by 0.25 percentage points on Tuesday this week.

Analysts say bids could total as much as $100 billion, and the stop out rate could be about 30-50 basis points above the minimum bid rate, but could be higher.

“We believe it will be closer to the one-month U.S. dollar LIBOR level than the one-month U.S. dollar OIS (overnight indexed swap) level,” wrote George Goncalves, chief Treasury/TIPS and agency bond strategist with Morgan Stanley in New York in a research note on Thursday.

One-month U.S. dollar LIBOR was 4.99625 percent on Friday.

Markets will be watching how the auction affects LIBOR, the London Interbank Offered Rates. If the stop out rate is lower than LIBOR, that may help bring rates down.

Meanwhile, the Fed will be closely watching unsecured loan rates, but it may take time for such rates to come down.

“If it works, one- and three-month interbank lending rates should fall to something closer to their historical levels, relative to the overnight lending rate,” said Stephen Cecchetti, professor at Brandeis University and a former senior New York Fed official. “I have my fingers crossed.”

It may also be hard to gauge pure fund demand.

“There may be an economic factor that plays into this” because some banks may be drawn purely by cheaper money, said Michael Feroli, economist at JP Morgan Chase in New York.

Summary auction results will be published on the Fed’s Web site on Wednesday.

Settlement for Monday’s auction will be on Thursday.

The Fed has announced it will conduct four auctions under the “term auction facility”. After the one next week, the next one will be on Dec. 20 for $20 billion over a 35-day term.

The third and fourth auctions will be held on January 14 and 28, with amounts yet to be determined.

The Fed could modify conditions on the auctions depending on how the initial ones play out.

New York Fed President Timothy Geithner said on Thursday that the new central bank actions are flexible instruments.

“With this framework of tools, we have the capacity to calibrate our response as market conditions change,” he said. (Additional reporting by John Parry, David Lawder; editing by Clive McKeef)

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