EC Right On Cue, Low Money Rates Are Not What You Might Think

If your usual clients don’t have any collateral, then you’ll lend your cash to anyone else who does – discounting the return down to whatever market-clearing rate. And that’s just what we’ve seen over the last three trading days (through last Friday) despite the Fed’s increasingly sizable numbers.

What about other markets?

As I’ve documented before, policymakers around the world hate LIBOR because it had been the one rate that was true to its mission during GFC1. Contrast that with fed funds which would often plunge to low levels. LIBOR was straightforward in demonstrating pressure and distress; fed funds, on the other hand, was at least confusing if not mistakenly reassuring.

If you are a central banker, of course, you’d prefer the latter.

Let’s go through a short exercise to illustrate what I mean. To begin with, the federal funds market is a true market; there’s no single rate at which real-world transactions take place. The effective fed funds rate (EFF; or EFFR as denoted at FRBNY) is the weighted average of all the unsecured trades that happen throughout the entire daily session.

The argument for fed funds, and against LIBOR, is that the former is based on deals that actually do happen. The latter rate, LIBOR, is put together from a survey of banks in the eurodollar market which asks them at what rate they would lend given the circumstances of that day. It’s been called a fake money rate for that reason.

And yet, LIBOR is absolutely superior, meaning more useful, at times like these – as you’ll see in a minute.

For the sake of simplicity, on Day 1 we’ll assume under normal conditions that they are four banks borrowing a total of $120mm at the different individual rates shown above. The combination of those four transactions puts the weighted average, EFF, right at 1%.

On Day 2, something happens which causes cash suppliers (dealers) to demand a higher return. Call it a supply shock (risk perceptions), where the same $120mm gets lent out but at higher rates across-the-board. EFF rises as a consequence, in exactly the way you’d picture a monetary disruption like this.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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Moon Kil Woong 1 month ago Contributor's comment

Very true, banks are not interested in lending unless you are willing to pay credit card rates. This has been true for quite some time and is why banks sell your home loan as fast as they can to Fannie Mae, Freddie Mac, or anyone who will take it as fast as they can. The risk is not adequate to the rate and is why lowering rates that are already low don't help much in creating more monetary expansion.

Actually, if the Federal reserve found a way to force down credit card rates it may encourage more spending on the lower end of the income bracket because its clear that the upper end of the income bracket isn't affected much at all to borrow anymore.

Terrence Howard 1 month ago Member's comment

That's a good point I hadn't though of.