Well, it's happening. The Federal Reserve is losing control of overnight interest rates, as I've been warning about for months. (See my past articles on the subject.) Since March 27th, the effective federal funds rate (EFFR) has been trading above the interest paid on excess reserves (IOER), currently set at 2.4%. The EFFR is now at 2.45% for a second straight day, up 4 basis points in 2 weeks. Other overnight rates are also being affected even more acutely, including the Secured Overnight Financing Rate (SOFR), the rate for overnight loans backed by Treasuries up 28 basis points, and the overnight bank funding rate (OBFR) which is just the EFFR plus Eurodollar loan rates. They're all trending higher. The OBFR is up 3 basis points since yesterday.
True, the end of the month is probably exacerbating the situation in money markets as tends to happen when demand for reserves peak in order to square monthly balance sheets, but the trend is clearly up for overnight rates.
The IOER was supposed to act as a ceiling for overnight rates by encouraging more overnight lending, but it isn't working. It is supposed to act as a ceiling by encouraging banks to lend out more reserves rather than keep them at the fed at lower interest rates. The lower the IOER, the more lending should happen, the lower the price of the loans should be by supply and demand. That's the theory. It's not working because, according to the St. Louis Fed, banks are hoarding their excess reserves in case of an emergency liquidity crunch. Take it away, St. Louis Fed:
Many commentators have pointed to post-2008 Basel III and Dodd-Frank regulations as having generated a large regulatory demand for high-quality liquid assets (HQLA), which include reserves. At first glance this explanation may seem unsatisfactory because HQLA also includes, among other things, U.S. Treasury securities.
Why should banks prefer reserves to higher-yielding Treasuries? One explanation is that Treasuries are not really cash equivalent if funds are needed immediately. In particular, for resolution planning purposes, banks may worry about the market value they would receive in the sale of or agreement to repurchase their securities in an individual stress scenario.
Translated into English, banks are worried that if they have a bunch of Treasuries, even earning higher yields, and they try to sell their reserves for Treasuries, they might take a loss if everyone is trying to sell Treasuries at once to get their hands on reserves. Another way of framing this is that banks are worried that in the next liquidity crunch, interest rates are going to rise instead of fall (Treasuries going down in price instead of up).
Anyway, the solution proposed by the St. Louis Fed is a "Standing Repo Facility". It's not quite a dorm for repo men, but basically a promise by the Fed to buy any Treasuries at an "administered rate" (back to this term in a bit) in exchange for reserves if needed. That way, the theory goes, banks should be perfectly fine holding Treasuries instead of reserves, because of the guarantee of a back button, and this, they say, should bring rates down because banks won't be so stressed about keeping reserves and will loan out whatever's left more easily.
The goal appears to be a giant transport operation of US Treasuries from the Fed's balance sheet to the banks. I don't know for sure what will exactly happen because this has never been done before, but I'm simply following logic here and trying to reason this out. From what I can see, this isn't going to work long term. If you think I'm wrong please comment below. This is uncharted territory so maybe I'm missing something here.
There are $1.4 trillion in excess reserves currently sitting outside the economy. There are currently 8 banks with about $784 billion of them. (See St. Louis Fed link above.) These are Bank of America (BAC), Bank of New York Mellon (BK), Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM), Morgan Stanley (MS), State Street (STT), and Wells Fargo (WFC). (The St. Louis Fed links to this article when mentioning the 8 banks that it says control $784 billion, and those are the banks listed in that article.)
First, here's what probably won't happen. If the Fed suddenly guaranteed a certain "administered rate" in exchange for Treasuries at any time of need and these Treasuries offer higher rates than either the IOER or the EFFR, then what happens to that $784 billion currently sitting outside the economy? It enters the economy to buy long term Treasuries, the only ones with rates substantially higher than overnight rates. The yield curve collapses as overnight rates stay stable and demand for long term Treasuries suddenly spikes by $784 billion, or worse, $1.4 trillion if all the banks want in.
We would see an explosion in the money supply as all those reserves flood the banking system, which become pyrimidally capable of being the basis for more fractional reserve loans, spiraling the money supply out of control.
Ah, but this probably won't happen because the Fed knows to counter this before it becomes an issue. The people at the Fed would say that they can sterilize this whole operation by simply selling the Treasuries on their balance sheet to the banks bidding for them. The Fed would take the excess reserves offered by the banks in exchange for Treasuries on its balance sheet and retire the reserves out of existence, shrinking the balance sheet, keeping the money supply more or less stable, and draining the banking system of excess reserves all at the same time. Basically, a huge amount of Treasuries would simply move from the Fed's balance sheet to the balance sheets of the banks currently holding excess reserves. It would be Operation Dynamo, the Evacuation of Dunkirk for Treasuries, evacuating them from the Fed and moving them to the banking system proper.
If it succeeds, goes the thinking (as far as I can tell) nothing would change other than the perception that the Fed has finally normalized its balance sheet, and congratulations. We all have faith in the Fed again. The Standing Repo Facility would stay open and simply be the reverse route right back to where we started should it be needed. If there's another liquidity crunch, the Facility would guarantee that all the Treasuries that the Fed just bought could all be exchanged right back to reserves if needed. It would really be Operation Dynamo with an "UNDO" button. That's the goal. Except there's one problem.
The Monkey Wrench
The fly in the ointment, the monkey wrench so to speak, is this. Let's go back to that "administered rate" thing. The whole idea of the Standing Repo Facility is that the Fed "guarantees" a certain price, an "administered rate" (as opposed to a market rate) for Treasuries so banks don't have to worry about booking losses in a liquidity crisis if they're stripped of reserves. But the Fed can't just "guarantee" a rate by magic. If the prices of US Treasuries really started to tank on the free market, and the Fed really just straight up guaranteed a certain rate for them all regardless of what's going on in the market, then everyone in the world would be selling all government paper it possibly could to the Fed to get those prices. The result would be money printing madness by the Fed to fill all those orders the likes of which we have never seen, not even in 2008. The danger is overnight hyperinflation.
The St. Louis Fed, which discusses the idea of a Standing Repo Facility, is probably aware of this, which is why there is this tiny little blip in its paper that puts everything back at Square One (my emphasis):
The Fed could easily incentivize banks to reduce their demand for reserves by operating a standing overnight repurchase (OTCPK:REPO) facility that would permit banks to convert Treasuries to reserves on demand at an administered rate. This administered rate could be set a bit above market rates-perhaps several basis points above the top of the federal funds target range-so that the facility is not used every day, but only periodically when a bank needs liquidity or when market repo rates are elevated.
An "administered rate" set "a bit above market rates"? And what if market rates tank and banks are still stuck with those losses like they fear? Are they going to go to the Fed just to get an even worse rate? What would be the point? The standing repo facility is not a guarantee at all. There is no guarantee. Price controls do not work, not at the consumer level and not at the central bank level either. There is no undo button. It's a one way street.
Does the St. Louis Fed realize this? Does Jay Powell? If the banks currently holding all those excess reserves realize the internal contradiction here, sleight of hand or what have you, of an administered rate set above market rates, they're not going to buy the Fed's Treasuries in the first place and it's not going to work. On the other hand if they don't realize the internal contradiction and they do buy the Treasuries in exchange for reserves thinking they can just press the back button when they need to, then they're just getting trapped into the very problem they're trying to avoid now by keeping the excess reserves in the first place.
In the best case scenario here, maybe overnight rates start to come down for a while if the banks fall for it, until, that is, the next liquidity crunch pops up and everything starts over anew, with no guarantee of anything by any Treasury repo men or their Standing Facility.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.