April 29, 2019
Last week we first noted that something unexpected has been going on in overnight funding markets: ever since March 20, the Effective Fed Funds rate has been trading above the IOER. This was unexpected for the simple reason that it is not supposed to happen by definition.
As a reminder, ever since the financial crisis, in order to push the effective fed funds rate above zero at a time of trillions in excess reserves, the Fed was compelled to create a corridor system for the fed funds rate which was bound on the bottom and top by two specific rates controlled by the Federal Reserve: the corridor “floor” was the overnight reverse repurchase rate (ON-RRP) which usually coincides with the lower bound of the fed funds rate, while on top, the effective fed funds rate is bound by the rate the Fed pays on Excess Reserves (IOER), i.e., the corridor “ceiling.”
Or at least that’s the theory. In practice, the effective FF tends to occasionally diverge from this corridor, and when it does, it prompts fears that the Fed is losing control over the most important instrument available to it: the price of money, which is set via the fed funds rate. And ever since March 20, this fear is front and center because as shown in the chart below, starting on March 20, the effective Fed Funds rate rose above the IOER first by just 1 basis point, and then, last Friday spiked as much as 4 bps above IOER.
To explain this bizarre phenomenon in which the EFF has been trading well above IOER in defiance of all of the Fed’s monetary orthodoxy, we laid out several possible explanations, including that i) money market outflows around the April 15 tax deadline date and elevated GC repo rates; ii) the continued decline in excess reserves, and most ominously iii) another acute dollar shortage developing across the US banking system.
One day later, PrismFP picked up on this topic and elaborated on the third, and most notable point, concluding that “there has been a dollar funding/shortage issue brewing under our nose for months; it is just coming to fruition now because we are noticing the DXY breaking out higher. In other words, with FHLB’s selling less FF’s, participants are forced to pay a higher rate to find funds, and that drives rate differentials towards the Dollar.” Some other notable observations from his latest note which we laid out last week:
The next question becomes what will the Fed’s reaction function will be? There has to be some hand wringing inside 33 Liberty Street these days. The brewing speculation in the market is the Fed could cut the IOER rate in an effort to bring down the FF rate as well, something the Fed has indicated it could do previously (Nov minutes).
This article was posted: Monday, April 29, 2019 at 4:58 am
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