What's Up with Fed Funds ?

The Fed funds rate has been creeping up in recent days. At first, many dismissed it as a technical quirk. In early February, the effective Fed funds rate firmed to 14 bp as it did in early March. However it did not stop there and yesterday was at 16 bp. Dealers report a tight market and it also appears to be reflected in the OIS-1 month swaps.

There is much talk about what lies behind this firm Fed funds rate. Several hypotheses focus on the agencies. There is speculation Fannie Mae is preparing to implement is distress mortgage purchase plan and is parking funds in the market. There is some talk that some US GSEs have reduced lines to European banks, forcing them to pay up for funds.

Some are suggesting that it may be linked to the discount rate hike and recent announcement of raising the SFP to $200 bln from $5 bln, though we are hard pressed to see the logic there.

There are some rumors that Fannie and Freddie allowed to collect interest on excess reserves, which presently they do not. This would seem to require an act from Congress, which in the current environment, strikes us as unlikely.

Funds continue to exit money market funds, largely it seems to lock in higher yields by lengthening duration and going into bond bunds. But this denies the money market funds some of the wherewithal to place in the Fed funds market.

We feel confident that there is no subtle policy shift behind the firmer Fed funds rates. Fed officials are still sticking to their mantra that economic conditions will "warrant exceptionally low rates for an extended period." That said, in the coming meetings, it should not be surprising that the Fed begins to play around with the wording so as to give them more degrees of freedom.

Although the first Fed rate hike may not take place as early as we have pencilled in (early Q3), we still remain of the view that the output gap is closed fastest in the US and that the Fed hikes before the BOE, ECB and BOJ.