Forex Investment and Currency Trading

Fed Chairman Bernanke’s speech last night on the Fed’s balance sheet and this morning’s press reports that the Fed has begun conducting small-scale tests of reverse repo trades have prompted much market discussion about the timing of the Fed’s exit strategy. A few points:

Fed Chairman Bernanke noted that “accommodative policies will likely be warranted for an extended period,” which is slightly different than the latest FOMC statement that said “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Bernanke may have changed the statement to “accommodative policies” from “exceptionally low levels of the federal funds rate” because he was speaking broadly on the Fed’s balance sheet. However, it may have been more intentional, in an effort to give the Fed the flexibility to tighten as it sees fit, using a number of policy tools.

Fed Chairman Bernanke noted three approaches to drain reserves (which market believes are in order of preference): 1) reverse repos with financial market participants, including banks, the GSEs, and other institutions; 2) term deposits to banks (”bank funds held in term deposits at the Federal Reserve would not be available to be supplied to the federal funds market”); and 3) selling a portion of Fed holdings of long-term securities in the open market. Interestingly, he did not even mention the possibility of extending the Treasury Supplementary Financing Program. Fed will likely start draining reserves shortly before hiking rates.

The FT reported that the Fed has begun conducting small-scale reverse repo trades. However, some do not believe this is a sign that the Fed is going to start draining reserves through reverse repos on a large scale. It does not seem logical for the Fed to start draining reserves as it is still expanding its balance sheet through the MBS purchase program. Bernanke even noted in last night’s speech that he expects the quantity of bank reserves to “continue to grow as the Federal Reserve purchases additional agency-backed securities.”

On a similar note, Bloomberg reported that the Fed is considering “accessing money market funds through clearing banks or creating a facility to drain the record amount of cash added to the financial system.” This is not surprising - the Fed must act to accommodate the balance sheet size of the primary dealer community in order for it to ultimately engage in large-scale reverse repos. Analysts judge this to be appropriate preparation for the eventual draining of reserves and do not believe it implies imminent action. Given the Fed’s focus on communication and transparency, market believes that the Fed will be sure to prepare the markets for its exit.