This morning the Federal Reserve formally addressed whispers regarding their intentions to conduct reverse repos in the open market. A "repo" is short for repurchase agreement. Reverse repo is short for reverse repurchase agreement.

In a repo transaction the NY Federal Reserve trading desk purchases assets, such as Treasury securities, from primary dealers with an agreement to sell them back to the dealers at a later time for a specified price. In a reverse repo transaction the Fed sells assets they own, such as Treasury securities, back to dealers for cash with an agreement to buy them back at a slightly higher price at a later date.

Here is the announcement...

Numerous Federal Reserve communications have indicated that reverse repurchase agreements are a tool that could be used to support a reduction in monetary accommodation at the appropriate time. Over the past year, the Federal Reserve Bank of New York has been working internally and with market participants on operational aspects of reverse repos to ensure that this tool will be ready when and if the Federal Open Market Committee decides they should be used. This work is a matter of prudent advance planning by the Federal Reserve, and no inference should be drawn about the timing of monetary policy tightening.

Repos and reverse repos have been in the Federal Reserve's toolkit for years, and the Federal Reserve has conducted both as recently as December 2008. The focus of recent work has been to expand our existing capability to conduct reverse repos with Primary Dealers to include "triparty" settlement.1 This has involved working with the triparty clearing banks and Primary Dealers to implement the necessary changes and updates. We have recently begun testing this capability with all involved parties and systems, and it is likely that the Federal Reserve will engage in additional tests in the future. No actual operations have been conducted as part of these tests.

Recent Federal Reserve communications have also raised the possibility of expanding the set of counterparties the Desk might employ for conducting reverse repos beyond the Primary Dealers. The Federal Reserve continues to study this issue, and no decisions have been made regarding the types of firms that may be included. We will engage market participants on this subject as appropriate going forward.

 

I highlighted the most important message: This work is a matter of prudent advance planning by the Federal Reserve, and no inference should be drawn about the timing of monetary policy tightening.

A repurchase agreement adds cash to dealer balance sheets and adds liquidity to the banking system. A reverse repo reduces cash on dealer balance sheets, effectively draining liquidity within the banking system. The Fed's recent discussion with primary dealers about their ability to participate in reverse repos is a function of the Fed preparing the market for a return to more normal monetary policies. View this as the Fed taking steps to properly research their exit strategies, not as an indication that they are ready to raise rates. Its like studying for an exam. The fact that it is a slow news day has put a bigger focus on the event than one would generally expect.

I will further explain this in a later blog post.  For now lets check on the mortgage market...

The FN 4.0 is -0-03 at 98-02 yielding 4.199% while the FN 4.5 is trading -0-02 at 100-22 yielding 4.418%. The secondary market current coupon is 4.363%. In the primary mortgage market, rate sheet rebate is marginally improved from Friday.

Here is the FN 4.5 two day chart...

Looking at the above chart you will notice that Friday's price ceiling is serving as today's floor of support. The morning trading range has been tight with exception of the market's knee jerk reaction to the above Fed press release. While we expect the range to contain progress in either direction, the slow news day makes another knee jerk reaction a possibility.

MBS trading flows are slow and rate sheet influential MBS coupons are currently taking directional guidance from the gyrations of the  yield  curve. Last week, fuller MBS coupons like 5.5s and 6.0s were the star performers as yield spreads continued to tighten. However on Friday that trend started to reverse course, this morning an "Up in coupon" correction continues as fuller MBS coupons are lagging their benchmark TSY hedges (yield spreads wider). Supply from mortgage bankers has been minimal so far today and "rate sheet influential" MBS coupons are performing in line with their benchmark TSY hedges (yield spreads unchanged).

BEWARE: Stocks are on the rise and TSYs have yet to react. If the 10yr TSY yield moves over 3.42%, "rate sheet influential" MBS prices will fall a few more ticks.

MBS, TSY, LIBOR QUOTES