Risky Debt and the Repo Rate
Interest rates are influenced by the risk of a loan.
The Repo Rate is the interest rates which banks pay on overnight lending backed by bonds as collateral. It hit all-time highs on Sunday night (7%) and Monday night (10%).[1]
Interest rates are rising in the repo market because either banks do not want to make risky loans to banks at low interest rates or there is not enough money available.
The Federal Reserve decided that there was not enough money available so Tuesday night they printed $75 billion and bought repo bonds to keep interest rates low.[2]
The Federal Reserve prints money (Quantitative Easing) to lower interest rates because they can use the increased supply of money to buy more loans than the US gov could sell. That decision is made by the Federal Open Market Committee (FOMC).
Federal Reserve Chairman Jerome Powell thinks that raising interest rates (specifically the Federal Funds Rate) will tank fixed income investments (bonds). In a 2012 Federal Open Market Committee meeting he said,
“I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.”
Today, September 18th, 2019, the Federal Reserve will decide whether to raise, keep neutral, or lower interest rates. Specifically, they will set the Federal Funds Rate.
The Federal Funds Rate is that rate at which significantly large financial institutions lend each other money overnight.[3] The money is uncollateralized, meaning that if a bank defaults there is nothing for the lender to repossess, unlike the repo rate.
Last night, Tuesday, the effective Federal Funds Rate was higher than the Federal Funds Rate. This means that the interest rate on overnight lending was even higher than what the Fed had set overnight lending to be, FOR THE FIRST TIME EVER.[4]
This is because as money is printed, the risk of the money becomes worth less and lenders want higher interest rates to cover the loss in purchasing power.
The author’s theory is that the Fed is losing control over the interest rates because of risk. Either the FOMC prints money to try to keep interest rates low and risks devaluing the dollar, or the Fed raises interest rates and blows “fixed income duration bubbles.”
One important fixed income investment is a government bond. Currently, the USA owe $22 trillion, not counting state, local, and personal debts.
There are 4 ways that the government debt can be resolved:
1. Default
2. Print money (lower interest rates)
3. Revalue debt against gold
4. Cut social and military spending while raising taxes
“The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.“ -Former Federal Reserve Chairman Alan Greenspan, Meet the Press, August 7, 2011.
The Fed has been printing money to lower interest rates since 1987 and especially since the Great Financial Crisis (2007-2009) so that the USA can afford to pay the interest on their debt and stocks can remain in a bubble.
Interest rates at historic lows do not reflect the historic debt. There is a risk that the debt will be defaulted or inflated away.
“Today is already the tomorrow which the bad economist yesterday urged us to ignore.” -Henry Hazlitt, Economics in One Lesson.[5]
When interest rates reflect the risk of inflation or default, there be a depression. Bread and Circus only works so long as either taxpayers can afford the debt or people think that the dollar is valuable.
[1] https://www.zerohedge.com/markets/nobody-knows-whats-going-repo-market-freezes-overnight-rate-hits-all-time-high-10
[2] https://www.zerohedge.com/health/fed-begins-repo-operation-funding-rates-ominously-elevated-across-board
[3] https://fred.stlouisfed.org/series/fedfunds
“The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.
[…]
The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. As previously stated, this rate influences the effective federal funds rate through open market operations or by buying and selling of government bonds (government debt). (2) More specifically, the Federal Reserve decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity for trade. Whether the Federal Reserve wants to buy or sell bonds depends on the state of the economy. If the FOMC believes the economy is growing too fast and inflation pressures are inconsistent with the dual mandate of the Federal Reserve, the Committee may set a higher federal funds rate target to temper economic activity. In the opposing scenario, the FOMC may set a lower federal funds rate target to spur greater economic activity.”
[4] https://www.zerohedge.com/markets/fed-funds-prints-230-breaching-target-range-libor-replacement-soars-remarkable-525