Federal Reserve Watch: Rising Rates And A Much Stronger Dollar

by: John M. Mason

Summary

The Federal Reserve is moving into December and it looks more and more likely that it will raise its policy rate range by 25 basis points at its December meeting.

The Federal Reserve continues to position its balance sheet for such an increase as reserve balances have declined by around $171 billion since the middle of September.

Rising longer-term interest rates will make it easier for the Fed to raise its policy rate, but the stronger dollar is something Fed officials will also have to contend with.

It looks as if things are on track for another December increase in the Federal Reserve's policy rate, a 25 basis point raise in the trading range for the Federal Funds rate.

Currently, the trading range is from 0.25 percent to 0.50 percent. In recent weeks, the effective Federal Funds rate has been roughly at 41 basis points.

The new range is expected to be from 0.50 percent to 0.75 percent, with the effective Federal Funds rate being in the middle of the range, somewhere around 60 basis points to 65 basis points.

Federal Reserve Chair Janet Yellen gave testimony yesterday before the Joint Economic Committee of the U.S. Congress and, although she would not commit 100 percent to a raise in the rate at the next meeting of the Federal Open Market Committee meeting, she gave plenty of support to the idea that a rise would occur at that meeting.

And, the actions of the Federal Reserve over the past two months has, I believe, confirmed the fact that the Fed is definitely preparing the banks and financial markets for such a move.

In the month and a half leading up to the December move in the target rate last year, the Federal Reserve removed reserves from commercial banks to tighten up on reserve positions enough to support the rise in the rate.

This year the Federal Reserve has done the same thing. Since September 14, 2016, the Federal Reserve has removed almost $172.0 billion in reserves from the banking system. It has done this removal gently, not wanting to disrupt the banking system or cause banks to withdraw from bank lending as happened in the 1937 experience when the Federal Reserve moved too fast and banks basically closed the lending window. This latter action ended up producing the 1937-38 depression.

Over the past seven and one-half years, the Federal Reserve has been very, very cautious not to do anything than might trigger another experience like that which took place in 1937.

For one, the Federal Reserve has worked closely with the US Treasury in achieving this reduction in reserves. Rather than keeping the tax money paid to the Treasury in the commercial banks, themselves, the Treasury has moved this tax money more rapidly into the Treasury's General Account at the Fed.

Of the roughly $172 billion in reserves removed from the banking system, just over $88.0 billion, or slightly more than 51 percent, moved from commercial banks to the account Deposits with Federal Reserve Banks.

The next largest movement of funds came from Federal Reserve trading operations, with Fed traders using the tool, reverse repurchase agreements. Since September 14, almost $39.0 billion in reserves, or just about 23 percent of the $172.0 billion, have been added to the Fed's balance sheet resulting in a withdrawal of reserves from the banking system through the use of reverse repos.

About 12 percent of the total reduction in bank reserves, or, just over $20.0 billion, has come from coin and currency leaving the banking system. In more normal times, the Federal Reserve would often replace the reserves leaving the banking system from currency withdrawals through open market transactions in order to keep bank reserves constant.

During the period of time beginning with the end of the Fed's third round of quantitative easing, the Fed has not replaced these open market operations, using this drain as a way to "naturally" reduce the reserve balances in the banking system.

Almost another $20.0 billion, or just less than 12 percent, of the reduction in bank reserves has come from the run-off of securities from the Fed's securities portfolio. During the time period under review, the portfolio of mortgage-backed securities experienced a $15.7 billion runoff and the Federal Agency securities experienced a $4.0 billion runoff.

There have, of course, been variations in some of these items. For example, since September 14, as mentioned above, the accounts totaling reverse repurchase agreements, have increased by almost $39.0 billion.

Yet, over the past four weeks, this account has fallen by almost by close to $76.0 billion. Thus, the Federal Reserve has to use its tools to respond to "operating" factors in the banking system that impacts the flow of funds into and out of the banking system.

Also, as mentioned, the Treasury's General Account has increased substantially since September 14, 2016. But, over the past four week period, the General Account balance has decreased by almost $34.0 billion.

So, lots of things are going on underneath the surface, while over the longer-run Fed officials move to lower the amount of reserve balances in the banking system, preparing the banks for a rise in the Fed's policy rate of interest in December.

The interesting question, however, still relates to the future.

Yes, it appears that the Federal Reserve will raise its policy rate in December. But what about 2017?

The "forward guidance" given the market by Federal Reserve officials in late 2014 and early 2015, was that the Fed would probably raise rates four times in 2015, each raise being a quarter of a point. Only one rate increase took place.

For 2016, the "forward guidance" was also for four increase of 25 basis points each. And, it appears as if only one change will take place.

What about 2017? Well, Fed officials have been a little quieter about rate changes for 2017, but it seems as if the market expects that more than just the December 2016 raise will be in store.

And, with the financial markets taking longer-term interest rates to much higher levels over the past two weeks or so…the yield on the 10-year US Treasury note hit 2.35 percent today, up from about 1.75 percent just before the presidential election…the pathway is clear for the Fed to make several more moves in the year 2017.

With the rising market rates, however, one has gotten a stronger US dollar. Today, it cost somewhere around $1.0590 to buy one Euro. If the Federal Reserve raises its policy rate several times in 2017, it is highly likely that the value of the dollar will become even stronger.

Some of us are not afraid of a stronger dollar and I have argued that it would not be surprising to see $1.00 or less buying just one Euro in the near future.

However, we are not sure how Fed officials might respond to such a strong dollar. Well, 2017 is going to be an interesting year!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.