Rate Hike Mechanics and the Chief Mechanic

November 23rd, 2015 7:48 pm | by John Jansen |

That is the desk at which I began my bond market career in late 1979 under the tutelage of Peter Sternlight. I found my calling at the Open Market Desk and have been enamored of fixed income  markets ever since.

Via the WSJ:
By Katy Burne
Nov. 23, 2015 6:42 p.m. ET

When the Federal Reserve finally decides to raise short-term interest rates from near zero, it will be Simon Potter’s job to make it happen.

The 55-year-old, British-born head of markets at the Federal Reserve Bank of New York had never worked at a securities-trading firm before taking his current post three years ago. The economist manages the Fed’s $4.2 trillion securities portfolio and runs a team of nearly 500 traders and analysts. Now, Mr. Potter will be faced with one of the trickiest trading assignments around: making it more expensive to borrow money when the financial system is awash in it.

Fed officials are considering lifting short-term rates at their policy meeting Dec. 15-16 after leaving them near zero for seven years. Traders in Mr. Potter’s group have spent more than two years testing the levers they will use and trying to sell Wall Street on the idea that they can be effective.

“Our testing program,” Mr. Potter told money-market professionals at a dinner off Wall Street in mid-April, “gives us confidence that we have the necessary tools to enable a smooth liftoff.”

Some traders aren’t so sure. Already, the Fed’s benchmark federal-funds rate is proving difficult to control around the end of the month, when some banks retreat from borrowing to dress up their balance sheets.

If the Fed can’t raise its federal-funds rate from near zero—or lifts it and other short-term market rates don’t follow—its credibility and influence over the direction of the economy could be weakened.

“There are legitimate questions about the effectiveness of these new tools and their potential unintended consequences,” said Michael Hanson, senior economist at Bank of America Merrill Lynch, who previously worked in monetary affairs at the Federal Reserve Board. The federal-funds rate is the rate banks charge each other for overnight loans.

Mr. Potter is an Oxford-educated economist who joined the New York Fed in 1998 after eight years as an academic at the University of California, Los Angeles. Erica Groshen, now commissioner of the U.S. Bureau of Labor Statistics, said she gave him that first government job.

“His insight and instincts were so compelling that I hired him,” she said, “despite some colleagues’ worries that his analytical approach was too technical and abstract to be useful for day-to-day policy work.”

He built a reputation for blunt talk, smart analysis and commitment, according to people who know and have worked for him, as he rose through the ranks of the research and statistics department, eventually becoming co-head.

For years, he commuted two hours each way from Yardley, Pa., to arrive at the New York Fed’s wedge-shaped, limestone and sandstone fortress in downtown Manhattan by 7.30 a.m., a former colleague said. In 2011, he spent four months at the Treasury Department managing the team that produced the first annual report for the Financial Stability Oversight Council, a panel of top U.S. regulators created after the financial crisis to identify risks to the financial system.

“He understands the plumbing of the financial system probably better than anyone else,” said Torsten Slok, chief international economist at Deutsche Bank AG , who knows Mr. Potter from meetings, conferences and consultations with the Fed over the past decade.

Even so, Mr. Potter wasn’t at first New York Fed President William Dudley’s clear choice to run the markets group, people familiar with the matter said. Mr. Dudley was impressed by Alberto Musalem, who then worked at hedge fund Tudor Investment Corp., the people said.

A New York Fed spokeswoman said the contest was a tie, and Mr. Dudley ultimately decided the job would go to Mr. Potter as the insider.

After Mr. Potter took the job in June 2012, one of his first moves was to ask consulting firm McKinsey & Co. to suggest changes that would help him better manage such a large group and improve its efficiency, people familiar with the matter said.

Partly on McKinsey’s advice, Mr. Potter installed a chief operating officer for markets, Ray Testa, to give himself more time to focus on strategic planning.

Now, Mr. Potter has a 12-minute walk to the office from his apartment above a poster shop in downtown Manhattan. At work, he sits on the 10th floor, with his traders and analysts mostly fanned out across the eighth and ninth floors.

They monitor markets around the clock but trade for just 30 minutes each weekday. The team trades securities to keep rates in line with Fed policy decisions.

At 12:45 p.m., a window pops open on a system called FedTrade and plays a sequence of musical notes—F-E-D—to open trading, traders said. A clock counts down the remaining time, turning from green to yellow in the final three minutes and then to red as the last 30 seconds tick off. The music plays again when the operations’ results are announced.

The last time the Fed raised rates was in 2006. It historically has done so by reducing banks’ reserves of money by selling them Treasurys from its portfolio. With less money on hand, banks would pay more to borrow in the federal-funds market, pushing up the Fed’s benchmark for short-term rates.

The problem now is that years of effort to stimulate the economy have left banks with more than $2.6 trillion in reserves, a thousand times more than before the crisis and too much to absorb with Treasury sales without crushing the U.S. bond market. So, the Fed has come up with new tools.

One is to pay banks a higher interest rate on reserves they park at the Fed. The other uses “reverse repos”—temporary trades in which the Fed borrows from money-market funds and some other lenders by selling them Treasurys that it agrees to repurchase, or “repo,” the next day.

Reverse repos have been around for a long time. Mr. Potter’s deputy, Lorie Logan, helped figure out how to use them to raise rates. In theory, they will set a floor under interest rates, because it wouldn’t make sense for anyone to lend for less than they can make lending to the Fed, which is perceived to be risk-free.

In practice, controlling rates already is proving to be a little tricky. The Fed has targeted a range of zero to 0.25% for its benchmark rate since late 2008. Most of the time it sits near the midpoint of 0.13%, but at the end of recent months, when banks under pressure from new regulations have scaled back borrowing, it has fallen to 0.07%.

At the April dinner in New York, Mr. Potter said that his team’s testing showed the tools had managed to set only a soft floor under short-term rates.

Mr. Potter’s team has been hosting lunches roughly every six weeks at the New York Fed to solicit comments from money-market participants on how well they expect the tools to work.

Some attendees said the conversation is mostly one-sided; Mr. Potter’s group asks for input without giving much feedback.

“Recent experience suggests that the Federal Reserve’s new tools…can be very helpful,” Mr. Potter said in remarks Nov. 16 at a speech in London. “But we can probably still learn more about how best to employ them.”

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