U.S. repurchase agreements rose on Friday, recovering a portion of the week's losses that have come amid speculation the Federal Reserve could eventually cut the interest rate it pays on excess reserves to banks. Investors are mulling whether the Fed could follow the lead of the European Central Bank, which this month cut to zero the deposit rate it pays banks for parking money with it overnight. Fed Chairman Ben Bernanke, in speaking to Congress this week, listed a cut in the interest paid on excess reserves (IOER) as one of the tools available to the central bank in its efforts to prop up the economy. Some investors believe the Fed may actually take the step, and the rate on repos secured by Treasuries has dipped this week as a result. Repo rates were last quoted on Friday at 21 basis points, up from 17 basis points on Thursday but down from 29 basis points on Monday."Although cutting IOER received only a peripheral mention by Bernanke and has not been listed as a policy option in the Federal Open Market Committee minutes since last year, the market has begun pricing in a cut," said Joseph Abate, market strategist at Barclays Capital in New York.
Abate adds however that he considers it "unlikely" the Fed will cut IOER, which currently stands at 0.25 percent. Separately, euro zone money markets have been wary of pricing in any prospect the ECB might cut its deposit rate below zero, but there are signs that such an unprecedented move is no longer considered unthinkable. The forward euro zone EONIA overnight interest rate for December traded at 6 basis points on Friday, less than the average spread of 8 basis points over the ECB's depo rate seen in the past few months. The rate projected for December is just half of Thursday's 0.12 percent EONIA settlement and indicates that the market is pricing in a tiny possibility that the ECB deposit rate may go below zero later this year.
"It does not seem to have been any serious flows in the market yet, but some in the market are starting to talk about this," said Max Leung, an interest rate strategist at BofA Merrill Lynch Global Research in London. Recent comments from ECB policymakers suggested that the central bank is keeping the door open for further easing, but the form any such step would take is unclear. If the ECB ever does cut its refinancing rate from the current record low of 0.75 percent, the question arises whether it will keep the gap over the depo rate at the usual 75 basis points.
If the deposit rate turned negative, the ECB would have to change the way it manages banks' excess reserves in the current account as well if it wants to penalize banks for parking cash in the ECB's safe coffers rather than lending to each other or to businesses. The only certainty in the market about the ECB's next move is that it will not cut the depo rate again in the near future, because it will take several months to assess the full impact of the July 5 cut to zero. Many are already expressing serious doubts that the zero rate will spur activity in the interbank market and filter through to the real economy. In fact, some of the biggest money managers have already restricted access to European money market funds due to the almost non-existent returns. Besides, most banks are not lending because they do not trust each other and that may not change even if they are penalized for it."In an environment where it is return of capital that counts, rather than return on capital, you may well have to pay someone to be the guardian of your money," said Simon Peck, rate strategist at RBS in London."Just because the deposit rate is zero or going lower doesn't necessarily imply that straight away you can change your risk management framework."