August 29, 2007
Update on the fed funds market
|Aug 28||5.30||5 1/2||4 3/4|
|Aug 27||5.27||5 1/2||4 1/2|
|Aug 24||5.11||6||4 3/4|
|Aug 23||4.88||5 1/2||3|
|Aug 22||4.77||5 1/2||2|
|Aug 21||4.89||5 7/8||3|
|Aug 20||5.03||5 1/2||3|
|Aug 17||4.91||5 3/8||1|
|Aug 16||4.97||5 3/8||2|
The table at the right displays the recent numbers for the effective fed funds rate (a volume-weighted average of the rates on all overnight loans of Federal Reserve deposits) along with the highest and lowest values for any trade during each day, as reported by the Federal Reserve Bank of New York. On both Monday and Tuesday, the effective fed funds rate actually ended up above the Fed's nominal 5.25% target. This is the first time this happened since the tumult in short-term credit markets began August 10. We also saw a much more normal spread between the high and low trades of the day than we'd seen at any time since August 10.
The Fed continued to be in a position of adding reserves on Monday and Tuesday, implementing $9.5 billion in 10-day repurchase agreements on Monday and $2 billion in overnight repurchase agreements on Tuesday. In other words, insofar as the Fed intervened in markets on Monday and Tuesday, the net effect was to keep rates lower than they otherwise would have been.
I had described last week's data as suggesting a two-tier fed funds market in which the Fed had basically abandoned its target for the effective fed funds rate in order to keep the highest rates being charged from spiking excessively. This week's data look like a much more integrated market in which the Fed's actions would once again be consistent with an effective rate in the neighborhood of 5.25%. Even so, it is a market in which there is a remarkable demand for excess reserves, as evidenced by the fact that the Fed has injected so much in the way of reserves during the current two-week maintenance period and yet we're still seeing the effective rate trending above target on Monday and Tuesday. Evidently banks remain unusually averse to the prospect of ending the period short of their reserve requirements.
All of which speaks to a market in which there remains a lot of concern, but which appears to be functioning more normally than it did last week.
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Tracked on August 29, 2007 11:10 PM
A suggested draft for a Fed communique from their retreat at Jackson Hole:
The Federal Reserve Governors and Presidents want to make public their full awareness of the following facts:
* By August 15 hedge funds have received redemption notices from their clients, to be fulfilled by September 30, for an unprecedented total amount.
* In order to fulfill those requests, hedge funds will have to collectively liquidate a significant part of their huge positions in the debt, foreign exchange, equity and commodity markets between now and September 30.
* The liquidation of those positions will inevitably cause significant movements in all these markets.
* These movements, being inherently transient in nature, have a very low probability to affect economic growth, which latest data - particularly the recent July Durable Goods Orders report - shows to be proceeding at a satisfactorily robust pace.
In view of the aforementioned facts, the Federal Reserve Governors and Presidents state their unanimous resolve to not introduce any change whatsoever in monetary policy, in particular to the federal funds rate, in response to any movement, however large or steep, that might occur between now and September 30 in the mentioned markets. They view any such change as completely unnecesary for the purpose of ensuring a sustainable pace in economic growth. They are also aware that any such measure would not stand up to any examination on moral grounds, since it could justifiably be interpreted as having the purpose of bailing out hedge funds - which are definitely neither banks nor an essential or even important part of the financial system - and their clients - who are not exactly widows and orphans.
Posted by: Last Line of Defense at August 30, 2007 08:29 AM
The fed funds effective rate may be looking more normal, but the broad money markets are as dysfunctional today as at any time over the last two weeks. I think we get a temporary calm once we get past month-end, but the credit crunch in the banking system is unlikely to normalize anytime soon.
Posted by: Turbo at August 30, 2007 08:36 AM
Turbo is surely right that the broad money markets are still highly dysfunctional.
Even though, by all indications, interest rates are expected to decline over the next 6 months, the 6m Treasury bill is yielding 56 basis points above the 3m bill. Whereas the yield curve for Eurodollars (or just about anything except Treasuries) is downward-sloping in that range. Since interest rates are expected to decline, the 56 bp spread between 3m and 6m Treasuries is a lower bound on the associated "term risk premium" (though I may be mislabelling what is really a liquidity premium). What the heck is going on? Are people worried about a run on US Treasury money market funds? Have people become so incredibly risk-averse that they are willing to give up 56 bps to get the absolute safest asset in the world instead of the second safest, which is almost equally safe? Or maybe it's just banks being ultraconservative, figuring 3m Treasuries are the next best thing to excess reserves.
This also implies (if I'm doing the math right) that the forward TED-spread -- the implied yield spread of 3m Eurodollars over 3m Treasuries for transactions to be settled 3 months from today -- is tiny. Which is very strange, because it seems to imply that people anticipating 3 months in the future are actually less risk-averse than usual, even as spot pricing suggests everyone is much more risk-averse than usual.
Posted by: knzn at August 30, 2007 09:26 AM
(Actually, I don't think I did the math right. Now I get approx. 54 bps for the forward TED spread, which is at the high end of the normal range. But note the contrast to the spot TED spread at almost 200 basis points -- far above the normal range. This does suggest that investors think that the liquidity event currently in progress will be temporary.)
Posted by: knzn at August 30, 2007 09:46 AM
Probably just reflects money market fund managers avoiding corporate paper and trying to match some specific, very short duration for their fund.
Posted by: Anon at August 30, 2007 10:33 AM
Regarding the general argument that the Fed needs to loosen because of increase in spreads. What do you say to the view that the increase in spreads is a long-awaited phenomenon involving the repricing of risk. (Possibly including the collapse of some inherently unstable markets e.g. asset-backed commercial paper.)
Does it really make sense for the Fed to loosen just when the market is finally coming to its senses and recognizing what the meaning of the word risk is?
Posted by: Anonymous at August 30, 2007 11:12 AM
So, anony, you figure the Fed should default on the notion of "risk management"?
Posted by: calmo at August 30, 2007 11:39 AM
Not sure what you mean. Like most others, I've no problem with keeping discount window open to provide lifeline to banks/financial system.
Signs of recession still not particularly clear. As noted in 8/7 meeting inflation concerns exist.
Fed should continue existing policy and keep rates steady.
Posted by: Anon at August 30, 2007 11:42 AM
I agree that a lot of today's problems are the direct result of the Greenspan put, but this may be the wrong time for the Fed to be trying tough love. The probability of this leapfrogging right over rational repricing of risk to economic crisis feels pretty high to me. If you subscribe to the idea that excess credit has been an outsized factor in economic growth over the past few years, then how do you think the economy will react to a severe credit squeeze?
Posted by: Turbo at August 30, 2007 12:52 PM
I don't view this as a severe general credit squeeze. This is just a rather painful business of shutting down markets that should never have been created in the first place.
As for the commercial paper market, this debt will probably end up on banks books (which afterall is where it came from a decade or so ago).
Bank balance sheets will be much the weaker for the change, but I'm confident the Fed (esp. with Bernanke) can keep the situation from blowing into disaster. Businesses being forced to borrow at an incrementally higher rate from banks is hardly going to be the end of the world.
Posted by: Anon at August 30, 2007 12:59 PM
This isn't a severe, general credit squeeze - yet anyway. The liquidity problems are occuring because banks are being forced to use their balance sheets at a time when they're already collectively operating near maximum leverage - they have little capacity to expand their balance sheets and extend credit where cp cannot be rolled over. Banks, particulary IB's, also tap the cp markets to fund their general operations. This has nothing to do with paying incrementally higher rates, in many cases credit simply won't be available. The Fed is a very bureaucratic institution, so I doubt they'll be particularly forward-looking, or that there's really much they can do anyway.
Posted by: Turbo at August 30, 2007 01:32 PM
Because most CP has a bank credit line attached to it, I don't think the banks have a choice about putting this stuff on their balance sheets when it doesn't role over. It may make them undercapitalized, but that is the nature of taking on off-balance sheet risk. The banks can get credit from the Fed, which together with the OCC can choose to keep the undercapitalized banks on a lifeline if that is necessary for the financial system.
A cut in the Federal Funds Rate will hardly do anything to solve the problem that the ABCP market is not structurally sound. IB's tapping CP markets for general operations is playing with fire. As Martin Wolf, FT, put it they need to get burnt.
Posted by: Anon at August 30, 2007 01:57 PM
I don't see why the ABCP market is inherently unsound. It's certainly true that risk has been underpriced, and a lot of paper was issued that wouldn't have been viable in a less euphoric market. But -- aside from its regulatory function, which is a separate issue -- it's not the Fed's job to decide what the market's attitude toward risk should be, and it's certainly not the Fed's job to enforce an appropriate attitude by means of monetary policy. The Fed's job is to provide an elastic currency and to attempt to achieve reasonable price stability and maximum employment. If we do have a recession (which is a definite possibility with help wanted advertising falling to yet another 40-year low the month before the crisis began), it should be either because the Fed made a mistake (which is inevitably going to happen sometimes) or because the Fed was concerned about inflation risk. The Fed has no business taking a higher recession risk just so it can force Wall Street to take less credit risk.
Posted by: knzn at August 30, 2007 02:51 PM
ABCP is unsound because it has a huge lemons problem (http://www.rgemonitor.com/blog/setser/212869). Because this paper is backed by pass through of heterogenous underlying securities, it's guaranteed to run into an adverse selection problem at some point in time. Commercial paper has existed forever because it was backed by the full faith and credit of a specific company that would or would not go bankrupt -- that kind of paper at least that issued by non-financial institutions appears to be doing just fine (http://www.federalreserve.gov/RELEASES/cp/). What's not doing fine is the stuff with a built in lemons problem. It is not the Fed, but the market that has decided where this paper should go.
I have no problem with the Fed taking action to moderate a geniune recession on the horizon. But there isn't much evidence that this credit crisis is hitting non-financial firms or will turn into recession. (2Q growth rates anyone?)
Between the falling dollar, the endless current account deficit and asset price problem in the US, I'd say some inflation risk is on the horizon and neither raising nor lowering the Funds rate makes sense.
I really don't understand why you assume that the failure of a few large financial firms is guaranteed to cause a recession.
Posted by: Anon at August 30, 2007 03:30 PM
Partial to the view expressed above (3:30) that a few large financial firms role/status is over-marketed in the possible precipitation of a recession...they just have better PR departments than, say, auto workers and soon, house builders, no?
Not so partial to this:
I have no problem with the Fed taking action to moderate a genuine recession on the horizon. I'm not convinced that this moderation (loosening) has any effect on the housing morass...which looks to me like orders of magnitude larger than just an episode of sales brought forward (autos).
Am I the only one bothered by Greenspan's "conundrum"...and the possibility that long term rates and mortgages might just ignore a declining prime rate?
Posted by: calmo at August 30, 2007 04:12 PM
I suspect that both the financial and the housing situation will continue to unwind for one to two years and that by the end of this process we will be deep in a recession. I also think that responding too quickly is a case of the "Greenspan put," that will only succeed in prolonging the unwinding of the financial situation and then of a recession driven by tighter lending.
Keeping long-run rates low is going to require maintaining the credibility of US financial assets abroad. A fast and furious cleaning out of financial deadwood is more likely to be successful in this aim, than taking ameliorative measures that will only lead to year after year of US based financial scandals.
Posted by: Anon at August 30, 2007 05:55 PM
The Federal Reserve report "Factors Affecting Reserve Balances" for the week ending 29 Aug. is now available here. It shows Loans to Depository Institutions (which I take to be the discount window) still running at a daily average of about $1.5b., as it was during the previous week. Is this a lot or a little?
Posted by: gordon at August 30, 2007 06:17 PM
Sorry, that should have been available here.
Posted by: gordon at August 30, 2007 06:20 PM
The market is far from normal. Overninght funding is not the stress point. What banks are struggling to secure and hold on to is term funding. The Libor market is effectively closed and the Libor curve has rocketed over the past two days with 3mth going to a new high yesterday. Look at yesterday's punitive lending by BoE to Barclays.
Posted by: fred at August 30, 2007 07:08 PM
To see long term trend go to St Louis Fed's FRED database (http://research.stlouisfed.org/fred2/series/TOTBORR?cid=122)
Posted by: Anon at August 30, 2007 08:02 PM
Anon: there isn't much evidence that this credit crisis is hitting non-financial firms or will turn into recession. (2Q growth rates anyone?)....
I really don't understand why you assume that the failure of a few large financial firms is guaranteed to cause a recession.
Nothing is guaranteed to cause a recession, but if the Fed was satisfied with 5.25% a month ago, it doesn't make sense that they should still be satisfied with it, because credit is tighter now, so it's as if the FFR was at maybe 5.75% a month ago. And when I see help wanted advertising making new lows month after month, I think the risk that we're going into a recession is something to be concerned about. I don't see much inflation risk: there's no indication that the economy is close to overheating. As for the dollar, it's better to weaken the dollar now while it's still popular, rather than wait for the market to lose its affection for the dollar and risk a major crash a few years from now.
Posted by: knzn at August 30, 2007 09:01 PM
The so called "return to normal" headline of this original post is completely absurd. I am not sure if anyone except for the few astute observers have noticed the Libor rate blowing out over the last few weeks. Well I have and I can tell you, what is going on here is very massive in terms of monetary scale, that the conglomerate of Central Banks will have to print money and print it fast to alleviate this situation. I can guarantee that this situation will make LTCM look like pennies. There is a massive shut down of short term financing that has created a complete dislocation of rates here and rates abroad, most notably the Libor rate, and I don't at least hopefully don't have to inform everyone the significance of that rate. I can tell you that hedge funds and banks all play the yield spread differential between eurodollars and Libor and right now the dislocation is massive and no doubt many firms are getting crushed. The scenario is this, The U.S. Subprime debacle occurs and the fixed income markets start pricing in rate cuts all across the U.S. coupon curve to the toon of almost 75bp by year end. Obvious play here would be this:
U.S. consumer will have to tighten up and the FED will have to cut rates. So any big institution will know that they are exposed to this sub prime mess, before anyone else,because regulators would have no clue and the very derivatives that Gspan and company hail as innovation are now at the very root of this very dangerous situation. The institution is the first to know they are taking massive losses and they also know that the FED will come to the rescue,so here is what they will do:
lets pile into the front of the curve and make back some of the money that our sub-prime funds are going to lose. We don't even have to spend any money on these positions we can finance them with short put positions in the front of the curve and buy our longer term calls with the proceeds, right? FED cuts rates eurodollars rally and we are bailed out again! well lets not forget that the Eurodollar front of the curve is directly priced off of the LIBOR rate which has been INCREASING in YIELD not decreasing because the banks have their tail between their legs and don't want to finance anyone.....So now all of our positions are losing money, our long calls our short puts, we get it from both ends..... and text book Bernanke is preparing his sugar coated speech for this weekend and will say that prelim GDP came out at 4% as expected the economy is doing great, but we will be willing to make necessary adjustments when needed to facilitate the soundness of our monetary system...... throw in a few good words from our fine Pres. Bush about helping the poor saps that bought homes when they should of been renting and the stocks rally to no end....hmm something is peculiar, stocks rise in Anticipation of a rate cut, yet the very instruments that a rate cut would affect sink to new lows...wonder what CNBC will conjure up next.....so when I see a headline like normalcy or anything of its kind, talk to the traders of this world and they will tell you that it is anything but.............
Posted by: magne13 at August 30, 2007 11:02 PM
just graph 3m ois vs. 3m libor to see whats really going on...
USSOC ICPL [curncy] vs. US0003M [index] on BBG
same in gbp and eur
Posted by: vern at August 31, 2007 01:58 AM
The assumption is that lowering interest rates increases liquidity, but what if lowering interest rates increases business activity increasing the demand for money and decreasing liquidity? The FED is working against their own objective but they don't seem to realize it.
Posted by: DickF at August 31, 2007 06:26 AM
Take a look at the August Fed Funds futures contract.
It's settling down (on this the last day of August) at a level that indicates an average rate of 5.02% for all of August past.
The Fed has already cut by 1/4 point.
Enjoy it folks and keep one eye on the price of gold!!
Posted by: Constantine at August 31, 2007 10:49 AM