An Anomaly in Fed Funds Trading

One of my Finacorp colleagues pointed me to some Fed funds data this week, and it made me want to write an article. He pointed out something that looked anomalous about the way Fed funds is trading, namely, that on many days in the last month, some trades are going on where some banks out there are accepting almost zero for the rate on investing excess reserves.

Let me back up. We talk about Fed funds all the time, but we don’t often stop to talk about what it means. Banks and thrifts have to keep non-interest bearing reserve funds at the Fed. Those funds can be deposited by the depositary institution at the Fed, or, they can borrow the funds from another institution that has excess funds deposited at the Fed. Thus there is an active lending market between banks for reserves deposited at the Fed. The weighted average rate at which these overnight loans get done is called the effective federal funds rate.

The Fed influences where Fed funds trades through open market operations, where they lower the Fed funds rate by increasing the supply of reserves to the system through temporary repurchase transactions, and outright purchases of securities through the creation of new credit, thus expanding its balance sheet (a permanent injection of liquidity). The Fed raises the Fed funds rate by decreasing the supply of reserves to the system through temporary reverse repurchase transactions, and outright purchases of securities which reduces credit, and shrinks the balance sheet of the Fed (a permanent reduction of liquidity — rare).

All the guessing games that go on around FOMC meetings today, revolve around the Fed funds target rate. That’s the rate that the Fed in the short run says it will try to keep the effective Fed funds rate at, primarily through temporary measures using repurchase and reverse repurchase transactions.

Back to the Present

Since August 1993, the high and low transaction yields for Fed funds each day have been recorded. The following graph shows the high, low, and effective Fed funds rate from then until the present.

click to enlarge

As you can see, the difference between the high and low for Fed funds on any given day can be substantial. Most commonly, the big ranges happen near the end of accounting periods, or at minor financial panics, whether for legitimate reasons (LTCM, 9/11), or dubious reasons (Y2K). In any case, there can be a scramble for overnight Fed funds, leading to a very large high rate for the day. Conversely, there can be a very small low rate for the day when enough institutions have significant excess funds to lend at Fed funds, and few takers at some point during the day.

That range between high and low Fed funds can be quite large, as you can see in the following graph. In order to show the persistence of the range, to flatten out the influence of disasters, and quarter- and year-ends, I threw in a 22-day moving average, which is meant to approximate the rolling monthly average.

In this present environment, I am most concerned about how low Fed funds trade on a daily basis. Since that is a noisy figure as well, I applied a 22-day moving average there.

The range for Fed funds trading is high on a monthly average basis, but not as high as it was at points back in the mid-90s. Short-term interest rates were higher then, so there was more room on the downside for the range to expand, which is not possible today. What is unusual now is that the low trade for Fed funds is averaging near the levels achieved during the wondrous 1%-1.25% Fed funds rate policy that the Greenspan Fed instituted from late 2002 to mid-2004.

In the midst of a period where liquidity is so scarce, we have a situation where some banks are having a hard time getting a good yield from Fed funds. To summarize the situation, look at my final graph:

This is a scatterplot to show how the moving averages for low Fed funds vary against the range for Fed funds. The diagonal line is there for convenience, to show where the moving averages for the range and the low would be equal. Back during the 2002-2004 era, though rates were low, Fed funds traded in a tight band. In the mid-90s, rates were higher, but we had occasional periods where the range would explode for accounting or crisis reasons.

Now we are in a period where we have a volatile range for Fed funds amid low rates. This is unusual. I’m open to new ideas here, but it seems that the liquidity situation in Fed funds is volatile enough that some banks end up snapping at low yields at some point each day. Just another piece in a difficult policy period for the banks and the Fed. If I have to speculate, it indicates that some banks are already awash in liquidity, and aren’t sure what to do with it.

Comments

[DJINLOWELL]

Thanks David for your work in this area. I think you're on to something here. I've followed your lead and have done some data building on TED spreads and Non Financial Comm'l paper vs 2Yr US T-Notes and it's clear that while the Fed's recent actions have preserved the liquidity posture of money center banks and primary securities dealers, it appears that those entities are hoarding the "cash" due to their recent "near death" experiences and not increasing their lending further downstream.

This is a natural human reaction and shows that more time is needed for the fear (and mistrust?) factor(s) to dissipate. A sustained market recovery cannot occur without a significant clearing of these emotional factors; the value in your work is that you are providing us with a place to pick up the "early signals" that such a recovery is taking place. I hope it's soon, but we don't have much choice but to wait and see and let the credit spreads tell us when the "real healing" is taking place.

[User 165930]

I agree...the Banks are awash in cash...However, Bank cash does not necessarily mean liquidity in the market. As said before until the Banks "fear factor dissipates" we should see this trend continue.

[d_teller]

I also thank you for the compilation and analysis. My own take on the current problem is that the Fed may have backstopped the larger banks and securities purchasers, but this hasn't penetrated to regional and local banks that need liquidity to handle commercial and short-term functions. i don't believe that the large banks that were supported by the Fed, which have seen their equity drop > 40%, will free up enough credit to actually move the liquidity to where it may be needed. Instead, I believe they will continue to try to acquire distressed asset holders, even if the assets that are held by these smaller firms are sound. While this may be good for the "capitalist" drive by these large institutions, I think the economic activity in the country, and even overseas, in developed Euro and Yen areas, will diminish.

If the govt. really wanted a stimulus, it should have exempted the first n-thousand $ of interest from federal taxes, instead of trying to give a handout. This would have prompted a larger number of tax-payers to put some money into the local banking centers, would have turned the savings rate to a positive direction, and probably would have cost the tax accretion of the Federal govt, considerably less. But I'm not a pandering politician, nor an even handed economist.