There are those people who will remain convinced forever forward that the Federal Reserve is run by capable technocrats absolutely skilled at maintaining for the free peoples of the United States their financial freedom. At a general level, they are thought to do so by signaling to market and economic participants just how these should respond to monetary policy inputs. To create and sustain such signals, those central bankers are said to exhibit a high level of on-the-ground proficiency by being the dominant, conclusive participants in money markets.

This policy intervention revolves around Open Market Operations (OMO) whose ultimate end (not aim) is its own balance sheet remainder: bank reserves. We are all taught that it is the OMO which determines money market rates, all because of that whole printing press thing we are further taught to presume spits out digital bank reserves.

Given this, it was a huge problem for Ben Bernanke’s group of officials twelve and thirteen years ago when money market rates were quite clearly being determined by anything else besides the Federal Reserve’s OMOs. You can read more about it here – and I urge you to do so in order to understand why the policy response had been so fatally flawed so as to more clearly appreciate what really must have happened; suffice to summarize, Bernanke’s crew believed they had created a situation where, during the worst part of the worst global monetary panic since the Great Depression, there came to be “abundant reserves.”

Straight away you have to ask, what good are reserves if they are abundant and the whole world melts down anyway? According to the doctrine, you aren’t supposed to ask that question.

Therefore, the episode teaches us two very important lessons. First, there’s obviously much more to the financial picture than bank reserves. The Fed talks about liquidity in regard to them, but they must be small issue to the wider world otherwise 2008 wouldn’t have happened at least beyond October.

There’s simply no way to reconcile a monetary panic with this absurd idea of too much money or liquidity. The level of bank reserves just doesn’t correlate to anything outside the immediate arena of bank reserves.

This remains mainstream thinking to this very day. The reason the federal funds rate declined was that the Federal Reserve, via TAF auctions, overseas dollar swaps, etc., created “too much” money which then got dumped into the federal funds market, pushing it down well below the policy target (beginning all the way back on August 10, 2007) requiring in the middle of September 2008 extraordinary central bank efforts to “drain” (SFP bills, reverse repos, etc.) all this “excess” liquidity.

Too much liquidity during the worst global firesales and liquidations in four generations. Huh?

Just as, however, there is an interest rate fallacy which interprets longer-term bond yields differently (meaning, correctly and consistent with actual history) than the textbook, there are potential missed associations at the shorter ends, too. You can read more about them here – and, again, I urge you to do so in order to understand why the policy response had been so fatally flawed so as to more clearly appreciate what really must have happened.

Suffice to further summarize, low rates don’t necessarily equal overabundance of liquidity, money, or whatever you wish to call it. Absolutely true of federal funds back in 2007 and 2008 (up to the introduction of ZIRP, which was merely the Fed catching up to where EFF, the effective federal funds rate, had already been for months), but also equivalent yields on Treasury bills.

During a liquidity squeeze, we expect, and the textbook says, that the price of money must rise and if sufficiently disorderly do so up to a harmful level. We’re left to presume that price always equals a money rate.

In terms of secured interbank money, repo, a money supply shortage doesn’t necessarily dictate a rising GC repo rate (the cash side). For those who paid close attention to what was really going on back then monetarily in terms of collateral and the seismic, systemic fallout from big problems in it – for the love of God, I implore you to do so in order to understand why the policy response had been so fatally flawed so as to more clearly appreciate what really must have happened – the effective price being squeezed upward may instead relate to the collateral rather than the cash.

This can lead to confusion; if the price of collateral drives upward due to any shortage of it, since collateral is itself financial debt instruments, including the most highly prized T-bills, a rising price produces a falling interest rate. What looks like helpful monetary abundance may instead be the destructive product of repo collateral shortage (especially when considering the re-pledging and rehypothecation regimes of securities lending).

It can become even more confusing given how federal funds, short-term bills, and several of the Fed’s policy windows are often substitute money equivalents.

In 2007 and 2008, lasting through the first quarter of 2009, were low rates, even negative T-bill equivalent yields, consistent with a global dollar situation benefiting from an abundance of liquidity; or, on the very opposite side, the clear products of a repo-driven crisis which the Federal Reserve and abundant bank reserves remained powerless to thwart month after excruciating month?

As noted last week, and at seemingly regular intervals the past few months, bill rates have been falling again. Now federal funds rates are, too. Over the past week or so, since January 21, the effective fed funds (EFF) rate had dropped one and now two bps. While it doesn’t sound like much, down near zero this indicates some significant changes.

What has changed?

According to the mainstream version, surprise, a flood of liquidity; already over-abundant, bank reserves are about to become even more so. Once the federal government gets its act together, it will spend huge amounts on more “stimulus.” The technical mechanics of this are: Treasury has a huge balance sitting in its TGA account from monetized debt sold to banks last year subsequently bought by the Fed, so as it draws down on TGA via disbursements, the TGA funds get converted to bank reserves and then to bank customer deposits.

There’s also a statutory issue with the debt ceiling in which the TGA is typically drained as one of Treasury’s “extraordinary measures” to deal with any prolonged political impasse. Secretary Yellen has one possibly on her calendar already in the coming months.

Thus, with hundreds of billions about to be unleashed, we are told that much of it will get shoved into short-term money markets therefore plunging money market rates downward toward zero from this about-to-be-overabundance of money (thanks to J Fraser).

The primary issue [with falling short-term rates] is a wave of cash set to hit this part of the market as the Treasury, now run by Janet Yellen, looks to slash its $1.61 trillion cash balance in the next several months to abide by federal debt-ceiling rules. That means auctioning fewer bills and increasing bank reserves instead.

As a consequence, the wise technocrats at the Fed seem to be considering a future upward adjustment in IOER perhaps during its March FOMC meeting, at the earliest, in order to (theoretically) pull the entire short-end away from zero.

For the mainstream view, there’s always abundant reserves and this will explain, for those who follow it, what’s transpiring if only in the narrowest sense of short-term interest rates. 

In the wider context of everything else, you’d have to completely ignore the world around “abundant” money. To start with, bill rates haven’t just decided to decline over the past few weeks anticipating Janet Yellen’s political headaches. They’ve been on a slower (price) ascent going back months; the “too much” money theory is coming late to a risk-aversion party that’s been increasingly attended for quite some time already.

It’s only recently they’ve been given a little extra thought and attention, a puzzle for the mainstream to reverse engineer through association with future actions that haven’t happened rather than a monetary environment that may exist today at less than desirable tolerances. The TGA balance, for one, hasn’t budged. Not yet.

And if “reserves” weren’t pouring out of it into deposit conversion at commercial banks last month, where’s this downward lurch in federal funds coming from? An overnight rate ought not to be considering conjectured possibilities months down the road, focused entirely and instead upon, you know, what would happen overnight.

In that sense, T-bills offer the technical answer, too. Quite simply, as a money alternative, if for some reason demand for T-bills rises significantly then cash investors not directly affected by this bill demand would seek out higher-paying alternatives elsewhere to lending the federal government at lower rates for term (even as short as a 4-week bill). You might even consider federal funds as one such substitute.

Therefore, as bill rates fall it pushes some participants into even unsecured markets (including those covered by LIBOR), linking the decline in bills to a subsequent decline in other money equivalents. That’s just what we’ve seen over the past six and seven months, not just in January 2021:

And it’s not just been bills; look at short-term notes (2s shown above) where yields going back to November have fallen sharply. Risk aversion. 

Were investors in 4- and 8-week bills worried about diminished supply five or six months into the future? Are those buying the same in January taking Janet Yellen’s temperature for her department’s situation several months still down the road?

Or are collateral considerations driving an increase in demand for bills which has become more noticeable to the point other money alternatives being affected as close substitutes?

Obviously, by the way I’ve structured these questions you know which way I’m leaning (not that this would be a surprise anyway). And, as I pointed out last week, this view does extend more consistently into the long end of the yield curve, too; as in, why longer-dated Treasury note and bond rates haven’t moved more than they have. Despite so much supposedly going right, from vaccines to inflationary reflation, it’s curious that the yield curve hasn’t decompressed further than the relatively tiny bit we observe.

The curve – the entire curve (above) – remains behind/underneath where it was a year ago when the world was moving toward, and getting to, a really dark place. And that darkness, you might remember, had quite a lot to do with T-bills and collateral bottlenecks. I’m not saying this is about to be repeated, just that there might not be as much going right currently as is commonly believed; and in realizing this, no need to wonder about future TGA draws and its effects given a more complete (honest?) assessment of where things really stand today. Thus, what today as it actually is might tell us about tomorrow. 

Some people, on the other hand, despite last year’s clear connection, they will remain convinced forever forward that the Federal Reserve is run by capable technocrats absolutely skilled at maintaining for the free peoples of the United States their financial freedom. To them, money is reserves and these are abundant; the people who create them say so. For others who can’t reconcile this view with anything else outside of reserve numbers, there are factors to consider which might drive bill demand higher, yields on them lower, for collateral reasons, which I’ll cover in Part 2.