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  • Fed Funds spread signals crash

    Fed Funds spread signals crash

    The last time the Fed Funds target rate got this out of line with the effective rate was in 1987, and from a base of over 6% not 2%. On a percentage basis, at three times the target rate the spread is unprecedented. It happened today.
    Fed funds jump to 6 pct in mkt, tripling Fed's target

    NEW YORK NEW YORK, Sept 15 (Reuters) - Federal funds traded in the U.S. interbank lending market were indicated to have jumped to 6 percent on Monday, tripling the target rate of 2 percent which the Federal Reserve sets.

    The move happened even after the Federal Reserve earlier added $20 billion of temporary reserves to the banking system via overnight repurchase agreements.

    Early Monday, at around 7:10 a.m. EDT in New York, federal funds had traded at 2.0625 percent. When market inter-bank lending rates shoot up, that often reflects distrust among financial institutions of lending to some other counterparties. Global market participants' risk aversion has surged on Monday as the U.S. banking crisis has escalated, analysts say.
    AntiSpin: The Fed tries to manage the economy and inflation by influencing short term interest rates. It does that by buying and selling government bonds in the bond market in what are called "open market operations." They set a target rate, such as 2%, then buy or sell bonds as needed until the effective rate in the bond market matches the target rate objective. Problem is, this process does not always work in times of crisis because the bond markets themselves may be dis-functional, as is the case today.

    Really, really dis-functional.

    In 1987 during the crash the Fed Funds target rate was 6% but the effective rate jumped more than two times to 16% as banks lost confidence in lending to each other. Today that spread looks benign.

    On Friday Sept. 12, the effective funds rate was 2.1 percent, only 10 basis points over the target rate. Now the effective rate is three times the target rate. What it means is that the banks are so distrustful of each other's credit that they do not want to lend to each other. Who can blame them? Lehman Bros. went out of business today leaving its creditors holding the bag to the tune of $630 billion in defaulted debt.
    ``If the fed funds rate closes high today, I would be really worried as it would mean that there really is no money out there to be lent,'' said Stan Jonas, who trades interest- rate derivatives at Axiom Management Partners LLC in New York.
    - Bloomberg
    These episodes usually don't last long. It will be interesting to see what happens next.

    Today's mega spread between the Fed target and effective rate has not shown up in the Fed's graph yet today. Look for it tonight or tomorrow.



    Addendum: Sept. 16, 2008

    Appears that the Fed doesn't want to show the data on its web site so we've charted the data ourselves.



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    Last edited by FRED; 09-16-08, 02:43 PM.
    Ed.

  • #2
    Re: Fed Funds spread signals crash

    I've never quite grassped the significance of the Ted Spread, but Paul Krugman looks at it for signs of trouble and it's riding a rocket today.



    Ted Spread

    Comment


    • #3
      Re: Fed Funds spread signals crash

      Correct me if I'm wrong but I look at it like the difference between MSRP and what you actually pay :confused:

      Comment


      • #4
        Re: Fed Funds spread signals crash

        Originally posted by we_are_toast View Post
        I've never quite grassped the significance of the Ted Spread, but Paul Krugman looks at it for signs of trouble and it's riding a rocket today.
        ted spread - treasury/eurodollar spread. the eurodollar rate is an interbank rate, the treasury rate is riskless. thus the difference between the two reflects the degree of trust the banks have in each other.

        Comment


        • #5
          Re: Fed Funds spread signals crash

          Originally posted by FRED View Post
          Fed Funds spread signals crash

          The last time the Fed Funds target rate got this out of line with the effective rate was in 1987, and from a base of over 6% not 2%. On a percentage basis, at three times the target rate the spread is unprecedented. It happened today.
          FRED,

          I question your view of the spread as a percentage of the Fed Funds target rate. If the target rate was .25%, would interbank market rates of .75% be viewed as a bigger spread than the 1987 16%/6% spread?

          The flaw in the logic is using the ratio of the interest rates (6%/2%) rather than the 'principal plus interest rate' ratio (1.06%/1.02%). The banks do not fear losing only the interest, they fear losing their principal!

          In 1987, banks were demanding a 10% risk premium over the target rate. They were saying that over the course of a year of lending under those conditions, they would expect 8.6% (1-(1.06/1.16)) of the loans to default, resulting in the remaining 91.4% needing to pay 16% interest in order to make up for the bad loans.

          Today the market is saying that over the course of a year of lending under these conditions, they expect 3.8% (1-(1.02/1.06)) of the loans to default, resulting in the remaining 96.2% needing to pay 6% interest in order to make up for the bad loans. Hardly worse than '87 in my view. In fact, the expectation of defaults is less than half (3.8% vs. 8.6%).

          I know it's a terrible shit-storm, but I thought that deserved clarification. Correct me if I'm wrong.

          Jimmy

          Comment


          • #6
            Re: Fed Funds spread signals crash

            Originally posted by jimmygu3 View Post
            FRED,

            I question your view of the spread as a percentage of the Fed Funds target rate. If the target rate was .25%, would interbank market rates of .75% be viewed as a bigger spread than the 1987 16%/6% spread?

            The flaw in the logic is using the ratio of the interest rates (6%/2%) rather than the 'principal plus interest rate' ratio (1.06%/1.02%). The banks do not fear losing only the interest, they fear losing their principal!

            In 1987, banks were demanding a 10% risk premium over the target rate. They were saying that over the course of a year of lending under those conditions, they would expect 8.6% (1-(1.06/1.16)) of the loans to default, resulting in the remaining 91.4% needing to pay 16% interest in order to make up for the bad loans.

            Today the market is saying that over the course of a year of lending under these conditions, they expect 3.8% (1-(1.02/1.06)) of the loans to default, resulting in the remaining 96.2% needing to pay 6% interest in order to make up for the bad loans. Hardly worse than '87 in my view. In fact, the expectation of defaults is less than half (3.8% vs. 8.6%).

            I know it's a terrible shit-storm, but I thought that deserved clarification. Correct me if I'm wrong.

            Jimmy
            intuitively, fred's analysis makes sense... if i'm asking 2% and the other guy's demand 3x that's a bigger deal than if i'm asking 6% and the other guy is demanding 2.5x. does default risk figure into it? i mean they're buying tbills from the gov't. isn't the spread about inflation risk? i'm over my head here...

            Comment


            • #7
              Re: Fed Funds spread signals crash

              New York Fed Makes Unusual Intervention

              A sharp jump in fed funds levels apparently caught the Federal Reserve Bank of New York’s attention, driving it to implement an unusual late-morning intervention.
              New York Fed’s Geithner
              The overnight repurchase agreement is technical in nature, and exists simply to tweak liquidity levels. But it was unusual in that it followed a $20 billion overnight repo transaction that came at the typical intervention time of around 9:30 a.m. ET.
              The Fed accepted a massive $50 billion in overnight repos, driving traded fed funds to 4.25% from a high of 6.5% ahead of the Fed’s action. Recently, fed funds were last traded at 3.50%, according to Tullett data.
              The reason to come in again was simple. Market participants said the broad-based uncertainty resulting from the fallout of Lehman Brothers Holdings Inc.’s bankruptcy had driven up short-term funding costs as banks scrambled for cash.
              The Fed’s official target for the funds rate — it’s a market based rate on what banks charge to lend each other reserves — is currently set at 2%.
              While the funds rate is ultimately set by market forces, the difference between where it was trading and where the Fed wants it was unusually big, hence the reaction. The Fed funds rate is the central bank’s primary tool in influencing the overall course of the economy. –Michael S. Derby



              http://blogs.wsj.com/economics/2008/...-intervention/

              Comment


              • #8
                Re: Fed Funds spread signals crash

                Originally posted by metalman View Post
                intuitively, fred's analysis makes sense... if i'm asking 2% and the other guy's demand 3x that's a bigger deal than if i'm asking 6% and the other guy is demanding 2.5x. does default risk figure into it? i mean they're buying tbills from the gov't. isn't the spread about inflation risk? i'm over my head here...
                I'm usually in over my head on iTulip. I love it.

                Using your example, if one person lends $100 and asks for $102 in return while the other guy wants $106, I maintain that it's not as drastic as the situation where one guy wants $106 and the other wants $116.

                To illustrate further, if I loan you a million dollars for 1 penny interest, while the other guy wants a dollar in interest, that's a ratio of 100x, but it's inconsequential because it's the ratio of the full outlay to the full return (with interest) that matters.

                Banks are saying, "why would I loan bank XYZ money at 2.1% when I can loan the government money at 2.0% risk free?".

                Jimmy

                Comment


                • #9
                  Re: Fed Funds spread signals crash

                  I agree, great point. 6% is still not pricing in significant defaults, they'd prefer the dollar to lose purchasing power and have negative real returns than for defaults to occur, at the moment....while the fed still has control....but if the fed loses control...he who panics first wins. sorry he who is an insider wins

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                  • #10
                    Re: Fed Funds spread signals crash

                    Originally posted by marvenger View Post
                    I agree, great point. 6% is still not pricing in significant defaults, they'd prefer the dollar to lose purchasing power and have negative real returns than for defaults to occur, at the moment....while the fed still has control....but if the fed loses control...he who panics first wins. sorry he who is an insider wins
                    Even I can quote the most basic of banking rules:

                    1. The first rule of banking is: don't panic.
                    2. The second rule of banking is: if you're gonna panic, be the first.

                    Comment


                    • #11
                      Re: Fed Funds spread signals crash

                      The FRED graph isn't updating, it's still 9/11

                      UPDATE 2-Interbank dlr crisis deepens as o/n Libor surges

                      ...


                      Reuters charts showed overnight dollar deposit rates indicated as high as 11.50 percent on Tuesday but market participants said banks' reluctance to lend meant deals were only being done at much higher rates before easing as New York opened.

                      Sources in London said the drying up of dollar funds is as serious as anything seen during the entire global financial crisis.

                      "This is much worse than August last year," said one source.

                      Another said: "European banks can't get dollars. Banks are hoarding (cash) in case of payment issues," related to the collapse of Lehman Brothers.

                      "We need the ECB and SNB to start providing more dollars," he said.

                      The European Central Bank was among several central banks who pumped short-term funds into their respective local money markets on Monday to help ensure the functioning of these interbank markets. The Fed pumped in $70 billion of temporary reserves into the U.S. banking system on Monday.

                      ...

                      http://www.reuters.com/article/marke...rpc=44&sp=true

                      Comment


                      • #12
                        Re: Fed Funds spread signals crash

                        Originally posted by D-Mack View Post
                        The FRED graph isn't updating, it's still 9/11
                        Yes, we noticed. They are not updating the chart.

                        Ok, fine. If the Fed doesn't want to show the data on its web site then I guess we'll have to take the data and chart it ourselves.

                        Ed.

                        Comment


                        • #13
                          Re: Fed Funds spread signals crash

                          My own internal & proprietary "crash alert" signal fired earlier today, for what its worth.
                          http://www.NowAndTheFuture.com

                          Comment


                          • #14
                            Re: Fed Funds spread signals crash

                            Reflecting what's already happening, or predicting the next big move? If the latter, what sort of timeframe is it set up for?

                            Comment


                            • #15
                              Re: Fed Funds spread signals crash

                              The Ted spread is up to 3%. The Bloomberg chart doesn't even show it on its intraday chart. I had to hand draw it in the chart below (in red). It is way above anything it has been previously (Bloomberg's chart doesn't go further back than shown).

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