The FOMC Minutes from the March 17-18 meeting were released on April 8, 2015. Making money off the future direction of the entire stock market depends on correctly interpreting the FOMC Minutes.

In this report, I will break down the FOMC Minutes and we will try and get inside the heads of the Federal Reserve.

What You Will Learn

  • Text analysis of FOMC Minutes
  • Why this time, rate hikes are different
  • What is a reverse repurchase agreement

Text Analysis of FOMC Minutes

You can read the entire FOMC Minutes here.

The longest sentence in the FOMC Minutes:

In light of the considerable progress to date toward the committee’s maximum employment objective and the implications of that progress for the outlook for inflation members agreed to remove from the forward guidance in the postmeeting statement the indication that the committee judges that it can be patient in beginning to normalize the stance of monetary policy and to indicate instead that the committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.

The shortest sentence in the FOMC Minutes:

The unemployment rate declined to 5.5 percent in February.

I have created a word cloud out of the FOMC Minutes text.

(click on the word cloud image below to enlarge):
FOMC Minutes Word Cloud

The word cloud suggests that the lack of inflation and falling prices bother the Federal Reserve. Notice in the lower right hand corner that a new term has appeared this FOMC meeting that we haven’t seen much of in the past, “RRP”. RRP stands for Reverse Repurchase Program.

The top three word phrases from the FOMC Minutes are:
1 = “federal funds rate”
2 = “the labor market”
3 = “in energy prices”
4 = “measures of inflation”
5 = “labor market conditions”

These most used three word phrases suggest that the Fed is wrestling with setting the federal funds rate in an economy with a weak labor market, with falling energy prices, and falling inflation (disinflation).

Why This Time, Rate Hikes Are Different

Raising rates will be different this time, given the Fed’s large balance sheet… To raise rates, the Fed is going to raise the interest rate it pays banks to park their reserves at the Fed.Source: www.marketwatch.com

A mistake I see a lot of people make is to look at how the S&P 500 performed the last time the Fed hiked rates. There are two reasons why that can’t be done this time around.

1 – The Federal Reserve will use a very different method to raise rates than in the past. Banks are awash with more than $2 trillion in excess reserves, so to raise rates, the Fed is going to raise the interest rate it pays banks to park their reserves at the Fed.

2 – The Federal Reserve is not raising rates to combat inflation in a rip-roaring economy. The reason the Fed has raised rates in the past is to cool down an overheated market with runaway inflation. This time around, the Fed is raising rates simply because they have been near zero for too long and the Fed wants to get rates up before the next Bear market cycle hits. If rates are already near zero and a Bear market hits, the Fed has less power to stimulate the economy through the mechanism of lowering rates. Negative interest rates do not work very well and the Fed wants to avoid doing that if possible.

These two basic reasons are why it’s incorrect to use history and previous Fed rate hikes as a future indicator for how the stock market will respond. We truly are in uncharted waters.

What Is A Reverse Repurchase Program (RRP)

The Federal Reserve can’t just raise short term rates like they have in the past because banks have trillions in cash. If the Fed raises rates, rather than pay the higher rate, a bank will just pull from its reserves, or borrow from another bank who is pulling from their reserves. This would cause the Fed to raise rates higher and faster than they would like in order to have the intended effect. Think about all the businesses and consumers that are not flush with cash and how raising rates faster would really hurt them. The Fed has to focus on the cash reserves of banks when they raise rates.

RPs and reverse repurchase transactions are particularly useful in offsetting temporary swings in the level of bank reserves caused by such volatile factors as float, currency held by the public and Treasury deposits at Federal Reserve Banks. Source: www.newyorkfed.org

So two things are going to happen. First, to raise rates, the Fed is going to raise the interest rate it pays banks to park their reserves at the Fed. More banks are going to want to park their reserves at the Fed because the Fed will pay them more to do so. Now some banks will decline to park their money at the Fed and will instead want to draw down their reserves.

The Fed already has a tool for controlling bank reserves and it’s called an “RP” or “repo”, which is short for repurchase program or repurchase agreement. The Fed uses these repurchase agreements to make collateralized loans to primary dealers. In a reverse repo or “RRP”, the Fed borrows money from primary dealers. The typical term of these operations is overnight, but the Fed can conduct these operations with terms out to 65 business days.

The Fed uses these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drains balances from the system. We are concerned only with reverse repos as that’s what the Fed will be using to drain bank reserves.

Fed reverse repos are where securities are moved against simultaneous payment. In this case, the Fed sends collateral to the dealers’ clearing bank, which triggers a simultaneous movement of money against the security. At this point, reserve balances are extinguished. When the deal matures, the dealer sends the collateral back to the Fed, which triggers the simultaneous return of the dealer’s funds. This act re-creates the reserve balances that were extinguished on the front leg of the transaction.

The bottom line: reverse repos will allow the Fed to reduce its balance sheet at a leisurely pace without worrying about crashing the asset prices it sells (Agency MBS, Agency Debt, Treasuries), and without causing interest rates to spike higher.