Post-FOMC Yields 1: The Fed’s Floor Is NOT Useful

June 25, 2021

Post-FOMC Yields 1: The Fed’s Floor Is NOT Useful

Financial markets rarely act as we expect them to

It has been a week since the Fed’s June 2021 meeting, which saw them raise the rate on excess reserves and reverse repurchase agreements by 5 basis points.

This was widely perceived by market participants to presage a more hawkish policy tone in the coming months, and they acted immediately, selling off USTs and driving yields higher.

Now that a week has gone by, and the market has had the time to process the Fed’s policy changes and their implications, how has the yield curve shaped up?

The US Yield Curve has flattened after the FOMC meeting on 16 June — *CMT Yields*

Here’s a snapshot of the yield curve from 1 month to 30 years out. As you can observe, the front end of the curve is still extremely flat – that is, nothing has really changed here even as the Fed is ostensibly preparing to tighten their policy stance.

The 2 and 5 year Notes are where there has been the most change, with both tenors quite clearly off their early June lows (10 June, the purple line).

Here’s a closer look at how the curve has changed.

Short term yields remain under the Fed's 0.05% RRP "Floor" — *CMT Yields*

At the short end, we can see that even though the Fed’s reverse repo facility is supposed to act as a floor on interest rates, 1 and 3 month Bills persist in trading below it.

The Fed’s thinking here is that financial institutions who have access to the reverse repo facility will not lend at levels below whatever rate the facility is paying. Which makes intuitive sense, except for the fact that the shortest tenors of Bills are trading at levels below the Fed’s 5 basis point floor.

Since these Bills also represent the highest quality collateral available in the financial system, yields lower than the Fed’s floor indicate very high levels of demand for collateral, or a shortage, if you will.

This is corroborated by the astronomical use of the reverse repo facility itself, now at levels close to a trillion. Such high demand would in turn explain why the front of the yield curve still remains so flat, with only 5 basis points separating 1 month Bills from their 1 year counterparts (at time of writing).

That being said, 1 year Bills have responded in more energetic fashion to the Fed’s actions. From their lows on June 10, 1 year Treasury yields are now 5 basis points higher.

More importantly, even as Bill yields at shorter tenors refuse to move above the Fed’s floor, 1 year Bills are now trading at 9 basis points, comfortably above the 0.05% reverse repo floor.

On top of this, they seem to still be moving higher, with yields higher than what they were on the day of the FOMC meeting.

In comparison, yields on the 1, 3, and 6 month bills are just about unchanged from their levels on that day (16 June).

To be continued…