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Fed Funds as the Canary in a Coalmine: Will Stocks Choke?

0 | By Shah Gilani

Now that you know what “fed funds” are, and how the Federal Reserve manages the fed funds rate, it’s time to understand what’s happening with fed funds lately and how it could choke the stock market.

Today, we’re going to talk about what the real pros are watching (and what you should be watching, too), big deficits, and bond vigilantes.

Then, later, I’ll show you what you can do to profit in the midst of the potential beginning of the end of the bull market…

EFFR vs. IOER

While everyone’s watching the fed funds rate, which the Federal Reserve announces as a range, real pros are watching where the effective fed funds rate “EFFR” (the actual rate that banks charge each other to borrow overnight) is relative to something called “IOER.”

No, IOER isn’t a Winnie-the-Pooh character.

IOER stands for the “interest on excess reserves” rate.

Since the financial crisis when the Federal Reserve created trillions of dollars for banks to buy Treasuries and mortgage-backed securities, which the Fed then bought from them, to the tune of about $4.5 trillion, banks have been awash in money.

Then, because the Fed wanted banks to make more money, because you might remember they were all pretty much insolvent and the economy, which relies on banks, was in something called the Great Recession, the Fed offered to pay banks interest on their excess reserves.

Excess reserves are funds banks have above the level of mandated reserves they’re supposed to maintain as a safety buffer against loans they make and deposits that can walk, or run out, at any time.

Banks were awash in excess reserves because they didn’t need to lend to each other because the Fed flooded all the too-big-to-fail banks with free money so they wouldn’t have to shut down, and because there was no demand for loans, on account of the Great Recession.

So, banks parked their excess reserves at the Fed, which paid them interest at the IOER rate.

Technically, even though the Fed mandates a range for the fed funds rate, it caps the top of the range by paying banks the IOER. They don’t expect the EFFR to go above their upper limit, which is the IOER rate.

Fast forward to today…

The IOER, interest on excess reserves, has been 2.40% for months now.

That’s a pretty good rate to get paid for parking money overnight at the Fed, especially when the U.S. Treasury 10-year bond is yielding about 2.50%.

The EFFR, the actual rate that banks are borrowing from each other, is 2.44%

That means the EFFR is higher than the IOER (2.44% vs 2.40%).

That means there’s demand for reserves.

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Some banks don’t have enough reserves, and they’re borrowing from other banks.

Lending banks, who are getting 2.40% from the Fed are taking money out of the Fed and lending it at 2.44% to banks that need it and must pay up.

What’s worrisome here is that banks that were slathered with free money for so long, are now borrowing from each other again, and paying up.

They’re paying above the level the Fed wants the real fed funds rate to be.

In fact, banks in the 75th percentile and above have been borrowing excess reserves above the IOER of 2.40% and above the 2.44%-2.45% EFFR big banks are paying. Some are paying up to 2.534%.

There are a few warning lights going off here.

First, banks need to borrow in the overnight market again, to meet reserve requirements.

Second, upward pressure on short-term rates, especially overnight and “repo” rates, is worrisome because banks and broker-dealers borrow at these cheap rates to finance the Treasuries and mortgage-backed securities they buy, and other trades they make, meaning they borrow to finance leveraged-up positions.

If the cost of carrying those positions gets too high, they’ll start reducing their portfolios, meaning they’ll start selling positions to reduce leverage.

Last, but certainly not least, if borrowing costs are above what the Fed wants them to be, then the Fed has lost, or I should say, is losing control of its ability to influence interest rates.

That’s really scary.

Big Deficits and Bond Vigilantes

What’s going on in the big picture is, the Fed created so much money for banks to buy Treasuries (and mortgage-backed securities), which the Fed immediately bought from the banks at higher prices so they could make a profit, that the Treasury could borrow whatever it wanted, increase the deficit as much as it wanted, on account of the Fed being the ultimate buyer of government bills, notes, and bonds, to the tune of about $4.5 trillion.

As the Fed raised rates last year, once each quarter, culminating in the December hike, the Fed chairman announced the Fed was letting its balance sheet (with all those government bonds, notes, and bills) runoff (mature and not be replaced, meaning no more Fed buying) on “automatic pilot,” and markets freaked out.

Since deficits do matter, eventually, without the Fed buying to replace the bonds maturing off its balance sheet, and the government needing to roll over and issue more debt every month, and sooner, the realization that higher rates would make it more expensive for banks and dealers to finance leveraged-up portfolios of bonds and stocks, panic struck.

That’s when the Fed backtracked.

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Nevertheless, what if interest rates keep ticking up? What if the Fed can’t tamp them down?

What if the bond vigilantes – big investors who sell bonds to protest fiscal policy, or monetary policy for that matter – start selling and push rates higher and higher?

It happened from October 1993 to November 1994, when big institutional traders sold U.S. 10-year bonds and yields climbed from 5.2% to just over 8.0% fueled by concerns about federal spending in what became informally known as the “Great Bond Massacre.”

It could happen again.

Bizarre remedy to balancing the EFFR and IOER.

On Wednesday this week, the Fed’s FOMC minutes revealed the governors voted unanimously to reduce the IOER rate paid on bank deposits maintained at the Fed. They lowered the rate of interest paid on excess reserves to 2.35% from 2.4%.

The Wall Street Journal said, “The change isn’t likely to be economically meaningful and instead reflects a technical effort to improve the way the Fed’s policy decisions are implemented in overnight money markets.”

What?

It’s bizarre that the Fed would lower the IOER to try and bring down the EFFR.

If banks need to borrow from other banks, and those banks with reserves parked at the Fed are getting less than they were before, it stands to reason that they’d take money out of the Fed and lend it at whatever higher rates they can get.

Maybe I’m wrong, maybe the EFFR will come down, maybe banks will lower the rate they charge other banks who need reserves.

Maybe.

Then again, if rates rise, especially if the EFFR rises above 2.45%, or gets above 2.50%, while the Fed’s trying to lower rates, look out below.

You’ve been warned.

Sincerely,


Shah

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