With Money Rates Down, ‘Something’ Is Up

Twenty-dollar bills are counted in North Andover, Mass., in a file photo dated June 15, 2018. Elise Amendola/AP Photo

Commentary

We have all been taught to associate low money rates with stimulus, and especially high money rates with trouble. And that can be true under certain circumstances. This theoretical world of easy interpretation doesn’t exist outside of the media or central bank econometric models.

History—even recent history—at the very least cautions for a more nuanced approach.

Take, for example, the situation in December 2007 when the Federal Reserve, under the leadership of its still-relatively new Chairman Ben Bernanke, began to figure out subprime wasn’t contained (because it wasn’t about subprime). After the clear breakdown on Aug. 9, the Federal Open Market Committee (FOMC) had simply followed its instruction manual: August (primary credit), then September (federal funds target) rate cuts, and a clear “message” for more “aid” in the form of same going forward.

Over the subsequent weeks, chaos in the monetary world only became worse. Bernanke’s group of policymakers were compelled to take steps our pre-crisis selves never imagined any Federal Reserve regime would ever take.

The unveiling of TAF (term auction facility) auctions announced on Dec. 12, 2007, along with the implementation of overseas dollar swaps, were greeted by widespread shock and disbelief. We had always been told that the most powerful monetary institution, the world’s money printer, could fix any problem with the quick stroke of a simple rate cut.

Instead, the TAF auction was initially (and continually) swamped by “U.S. banks” with mostly German names (U.S.-based subsidiaries of foreign mainly German parents). Add to that overseas flavor the obvious offshore nature of overseas dollar swaps, and if you had been paying any attention you would have very quickly realized how this was a global dollar panic (eurodollar) unlike what’s taught in quaint, outdated textbook theories.

The first of those TAF operations was held on Dec. 17. The very next day, Dec. 18, the effective federal funds rate (EFF; the market weighted-median of all the unsecured interbank lending that takes place in the federal funds market) plunged, dropping from 4.31 percent to 4.16 percent. At that time, the FOMC’s target was 4.25 percent, meaning EFF was substantially below what officials demanded it to be.

The day after that, Dec. 19, EFF would drop another 18 basis points (bps), falling under 4 percent.

Wasn’t that just the TAF auctions pouring major amounts ($20 billion) of cash and liquidity into these markets?

No. Setting aside legitimate objections about what’s at the other end of them (bank reserves) and whether these are useful forms of money (they aren’t), the Federal Reserve was sterilizing its activities anyway. In other words, the most Bernanke’s besieged policymakers attempted was to redistribute funding to the weakest firms (those who would bid the most for the reserves).

This does not and cannot explain both the presence as well as the persistence of low EFF before and after these auctions, indeed, from the very beginning throughout the entire monetary (not financial) panic.

And it wasn’t just an issue for federal funds. Repo rates such as that for GC repo (or general collateral, meaning a secured or collateralized short-term interbank funding arrangement using essentially generic U.S. Treasury securities as the collateral) would often plunge dramatically more than EFF.

On Dec. 18, 2007, the GC repo rate was just 3.525 percent, a whopping 63.5 bps less than EFF and 72.5 bps below the Federal Reserve’s fed funds target. Then rate went even lower on Dec. 19. These were chaotic results, clear signs of massive disorder, despite the TAF and the Fed’s (useless) overseas swaps, even if illustrated by falling money rates.

Transaction-based rates like EFF and GC repo don’t take into account what doesn’t happen in those markets. How could they? If, say, a risky borrower in fed funds (remember, unsecured) who yesterday the market had charged a higher rate to lend because of its perceived risk profile is completely shut out of the marketplace today, the effective median calculated rate (the effective rate) for the whole market will decline because of simple statistics.

And if the market should decide to deny federal funds lending to a lot of higher-risk counterparties out of general fear, their typically higher-rate transactions disappear from the math, skewing the average and median downward. The more the market grows illiquid for a wider variety of borrowers, apart from only the best of the best (those paying low rates), the lower the transaction-based rate will drop.

In that situation, falling money rates represent the very opposite from stimulus.

The same is true in repo: if there aren’t enough interbank borrowers with acceptable collateral, cash lenders will resort to accepting much lower rates from those borrowers who can post good collateral, which most often means U.S. Treasuries, likewise explaining the same behavior found of GC repo.

No matter what the Federal Reserve would try, nothing stemmed the disaster. Right from the start of Aug. 9, 2007, all the way through to the actual end of the monetary panic in March 2009, you can plainly observe (in the chart above) how there was nothing other than absolutely obvious chaos and disorder, more often than not (the London interbank offered rate [LIBOR] was the notable exception, for reasons I won’t get into today) presented in the form of low money rates (including T-bills, for direct collateral purposes).

As of Aug. 24, 2022, the GC repo rate (or broad general collateral, as it’s now known) stood at 2.26 percent. Another repo-heavy interest number, the secured overnight financing rate (SOFR), which encompasses a wider volume of repo funding, was put at 2.27 percent. Yields on four-week Treasury bills were thought to tally up at 2.29 percent, having been much, much lower in recent days.

All of those are less than the Federal Reserve’s so-called “floor,” the reverse repo rate (the way the Fed claims to manage money markets has been changed since 2008, no longer picking a single target as it had for decades up to its grand failures during the crisis), which currently stands at 2.30 percent. Even EFF, on Aug. 24, was barely 2 bps above it.

In recent months SOFR, repo, and T-bills have been much further below the Fed’s “floor” than now. And when they’ve been that low, that’s also when we’ve experienced gross illiquidity and bedlam in global markets, such as occurred in mid-March and especially mid-June.

These falling money rates weren’t “stimulus,” nor did they have much to do with the Federal Reserve at all. Similar to the conditions in 2007 and 2008, they describe a very different situation from the rationale of  “inflation is because too much money printing” that is widely accepted across the entire mainstream media (the same media which had prematurely congratulated Ben Bernanke for every ineffective gesture). Money markets are again behaving erratically in a way that favors no one.

This isn’t to say that we should expect a replay of 2008, or close to that degree of outright panic. On the contrary, bank failures are exceedingly unlikely. Disorder, chaos, and general illiquidity, on the other hand, we’ve already got that. The question now is what it all means moving ahead. If these rates continue to drop, we’ll actually have a good idea.

And that would be bad.