Weekly Charts
Each Thursday, the MCP Research team shares two charts we are currently looking at that bring insights into the current state of the markets. This week—overnight interest rates.
With any good party, there always a bit of ‘liquidity’ involved to help loosen people up and get a good time going. On the same token, if you think back to your worst parties, there was probably someone who took liquidity a bit too far.
The same is true for financial markets. With the right amount of liquidity, capital is able to flow freely – those who need loans are able to access them and those who give loans are willing to write them – which keeps the economy dancing. Figure 1 shows the Fed policy Interest on Excess Reserves (IOER) rate, against the Overnight Repo Rate. These two lines represent overnight, short-term interest rates, and we can interpret the spread between these lines as being the level of liquidity flowing through the system.
It is healthy to see repo rates trading below IOER. It implies that central bank policies are supportive, and that capital if flowing freely against the forces of supply and demand. When repo rates start trading above IOER though, as they did from 2018 to 2019, it represents a lack of liquidity – there is not enough cash in the markets to fund those who need to borrow, thus driving interest rates higher with the occasional spike.
Since the pandemic, with the unprecedented amount of quantitative easing implemented by the Federal Reserve, we may be for the first time entering an environment where there is too much liquidity to handle. This is evident in the fact that repo rates have drifted into negative territory over the past few weeks (Figure 2, investors are choosing to loan out cash today to receive less back tomorrow, they’ll paying someone to take their money). At the moment there is simply too much cash supply in the system, and given that the NY Fed forecasts the central bank balance sheet to expand by an additional $1 trillion in 2021, there’s a whole lot more in transit.
What happens if you drown an economy in liquidity? We’ve never partied this hard, so no one is quite sure. But if the Federal Reserve continues down this path, we’ll have definitively entered a negative interest rate environment by this same time next year. The Fed has explicitly stated that it does not want negative interest rates. Their only other response? Start raising interest rates.
With this in mind, it makes it rather likely the Federal Reserve will begin tapering QE much earlier than previously expected.
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