October 3, 2025 • 27 mins
We're used to talking about the Federal Reserve changing "benchmark interest rates." But the mechanics of how the central bank actually tightens or loosens policy are a lot more nuanced. For years now, the Fed's been doing this through the federal funds market — where US banks lend and borrow their excess reserves. But that could be changing. Last week, Dallas Fed President Lorie Logan argued that the fed funds target is outdated, and the central bank should be looking at alternatives. So what would those alternatives actually look like, and why do the intricacies of these short-term funding markets actually matter? We speak with Joe Abate, head of macrostrategy, at SMBC Nikko about this and the broader liquidity picture.
Read More: Logan Ushers in New Era of Debate on Fed’s Key Policy Tool
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Speaker 1 (00:02):
Bloomberg Audio Studios, podcasts, radio news.
Speaker 2 (00:07):
Joe one and Joe two. I always wait, yeah, I
have to remember that. Well, you can answer whenever you want.
Speaker 1 (00:13):
Okay, that sounds good, all right, I might just sit
back with this one. I might just listen to the
I might just listen to Joe's answers and then listen
to your questions, which would be better than mine. I
did a deadlist.
Speaker 2 (00:25):
I'm both the most popular trader and most successful trader
at Citadel that.
Speaker 1 (00:30):
Is going viral.
Speaker 2 (00:31):
H barges.
Speaker 1 (00:32):
This is an after school special, except I've.
Speaker 2 (00:34):
Decided I'm going to base my entire personality going forward
on campaigning for a strategic pork reserve in the US.
Speaker 1 (00:40):
Black goals.
Speaker 2 (00:41):
These are the important questions that robots taking over the world.
Speaker 1 (00:44):
No, I think that like in a couple of years,
the AI will do a really good job of making
the odd Launch podcast. One day that person will have
the mandate of Heaven.
Speaker 2 (00:53):
How do I get more popular and successful?
Speaker 1 (00:56):
We do have Welcome to lots More, where we catch
up with friends about what's going.
Speaker 2 (01:02):
On right now, because even when Odd Lots is over,
there's always lots More.
Speaker 1 (01:07):
And we really do have the perfect guest.
Speaker 2 (01:13):
I think we've been lying to our listeners and our viewers.
Speaker 1 (01:16):
Go on, this is intriguing.
Speaker 2 (01:18):
We keep saying the FED is raising or lowering interest rates.
Speaker 1 (01:21):
Yeah, oh, I like this. I see, I already see
where you're going with this.
Speaker 2 (01:24):
But actually there's this whole constellation of rates, and we
will never really specify which one.
Speaker 1 (01:31):
It's less of a lie, more of an omission, et cetera.
It is true, especially at the short term level, that
there are all these different rates and they sort of
get abstracted away because I guess they can be arbed
one way if there's between the two, if they ever deviate,
So the FED can influence these other rates, and obviously
generally strongly does, but there's no guarantee that all these
(01:53):
short term rates always converge identically.
Speaker 2 (01:55):
No, And we have seen, for instance, instances where the
market rates have gone on far far outside what the
FED is actually targeting. So I should just say when
the FED raises or lowers interest rates, it does it
through well, it targets the FED funds, right, Yeah, okay,
and I think everyone has heard of that. But the
way it mechanically does it has changed over time. In fact,
(02:18):
it changed in a pretty big way early on in
our financial journalistic careers, so we should definitely talk about it.
Who's the guy that we call when we want to
talk money markets and mechanics of interest rates go on,
It's Joe Abatte.
Speaker 1 (02:31):
I'm really excited.
Speaker 2 (02:32):
So Joe has actually left Barclay's after more than twenty
eight years and he's now at SMBC NICO. He's head
of macro Strategy, so we're looking forward to hearing even
more from him. Joe talk to us about how the
actual mechanics of raising changing rates has changed over time.
Speaker 3 (02:51):
So originally, the FED started with a scarce reserve regime,
and the idea was that the level of liquidity in
the system was kept a little bit short of what
banks really wanted to hold, and that created a little
bit of torque in this interbank market, the FED funds market,
and that allowed the FED to move the Fed Funds
(03:13):
rate to exactly where it wanted to set the target,
and the target was set at a pinpoint level of
interest rates. Over time, and certainly beginning in about two
thousand and eight, the FED shifted to a different format,
and in that format, the FED would supply an ample
(03:33):
or abundant level of reserves and let the Fed Funds rate,
you know, trade or at least, in this case, not
trade at some spread or band between an upper and
lower band where it set the target. And originally it
set the target range ban because it wasn't confident that
this new structure would keep the Fed funds rate close
(03:56):
to a pinpoint level. But if you supply an abundant
level of reserves into the system, what happens is the
Fed funds market changes fundamentally, it adapts, it adapts, and
as it adapted, what happened was banks stopped trading in
the Fed funds market. They didn't need to borrow reserves
(04:17):
anymore because there's because there were plenty exactly. So the
market kind of devolved into basically an interest rate arbitrage.
You have one set of borrowers and one set of lenders.
The borrowers in this market are generally non US banks
and the lenders are the home loan banks. And the
(04:39):
reason there's this distinction is because the home loan banks
can't earn interest on their reserve on their cash balances
at the FED, so they have an incentive to sell
their cash right into the FED funds market to non
US banks. We're simply making the spread between FED funds
(05:00):
an IRB and in an ample reserve IRB oh interest
on reserve reserve balances. And that spread has been very,
very stable for the last probably four years or so
at minus seven bases points because the Fed's been operating
(05:20):
in an abundant reserve regime. The abundant reserve regime first
came about because of QWI, right, So you expanded the
Fed's balance sheet, created all these reserves, so banks were
overstuffed with liquidity.
Speaker 1 (05:34):
I'm going to ask a question that's going to sound
very negative, but it's not. It's actually I mean it
very literally because I think this might help us understand
why we're having this conversation. Who cares?
Speaker 3 (05:45):
Who cares about these.
Speaker 1 (05:47):
Any of this? And I do, and again I do
not mean this in the like a dismissive way. I
mean all of these things, like these short term things
that basically are equivalent, they could be away. The FED
seems to have a lot of control over these marks
gets in the end, even if it's not targeting one
or the other, the short term interest rate is basically
where the FED wants it. By any of these measures.
(06:09):
So literally, who cares about the plumbing?
Speaker 3 (06:12):
So the reason I think care about the plumbing is
that the FED uses it to communicate its policy intentions.
So it needs some sort of barometer, some sort of
measure for the market to be able to interpret what
the Fed's intentions are. So there's a twofold implication, if
you will, for the Fed funds market. One is the
(06:33):
FED uses the Fed Funds rate to communicate its policy intentions,
so raising rates, lowering rates, And it uses the dot plot,
for example, defined as the FED funds rate to provide
forward guidance to tell the market how far we're going
or what we see as the endgame potentially for interest rates.
(06:55):
And the second element is kind of more of a
mechanical one, which you're from to is the plumbing, which
is how does the Fed's intentions get translated into bank
deposit rates, mortgage rates, etc. Right. And one way to
think about this is that all of these term interest rates,
(07:16):
tenure yields, et cetera. Are all a reflection of what
you're expected. Path of the Fed is right defined as
Fed funds plus some premium right to reflect the term
risk that you're taking or inflation risk, et cetera. And
therefore there's a linkage between the overnight rates, the communication
(07:36):
of policy, and how it's transmitted to the broader financial
market system.
Speaker 2 (07:43):
I do think in terms of signaling the central bank's actions,
it is kind of funny that, you know, we're so
used to thinking of the Federal Reserve as a very
targeted institution, but when we're talking about reserves, the language
they use is like excess, abundant, yample, and there's no
hardcore definition of what those actually are. But I should
just say, the reason we were talking about this is
(08:05):
because everyone in money markets is talking about this right
now because Lori Logan at the Dallas FED, she did
a speech last week and a paper I think, basically
saying that the US the FED should move away from
targeting FED funds and look at some different ways of
targeting rates. Basically, was that a surprise to you when
(08:26):
you read the speech?
Speaker 3 (08:28):
It was a little bit of a surprise, since we
didn't really think that the Fed was preparing to actually
change policy rates. But the overall reasons for why they
might have to move away from a FED funds target
are pretty well known. So again, as I described the
Fed funds market earlier. Right, you've got one set of borrowers,
(08:50):
one set of lenders. It's become kind of a Roman lake. Right.
The provinces around the Mediterranean Wall spoke Latin. So in
a effect, there's not a lot of activity going on
between the FED funds market or the reason to borrow,
So it just becomes a communications device. So if you
(09:12):
move to a different barometer, let's say a triparty repo rate,
we can go into details about what exactly that means.
Speaker 2 (09:19):
So one that would be based on an active market.
Speaker 3 (09:21):
Correct, you would get not only the communications element, but
you'd also get a feedback on how well the FED
is doing and managing liquidity. Now, if reserves are always abundant,
I don't really need that information, right, I know that
reserves are abundant. But if I want to run an
efficient balance sheet for the FED, in other words, one
(09:45):
that's not any larger than it needs to be to
control interest rates, then I have to kind of bring
down the level of reserves in the system and monitor
as I bring down the level of reserves. What's happening
with liquidity in the overall system? Is it, as you said,
is it staying within the bands or is it moving
outside those bands and creating other sorts of distortions. And
(10:09):
that's why I need, hopefully a market traded instrument, and
that would be in this case the repo rate.
Speaker 1 (10:16):
What is the cost of running an inefficient balance sheet
or a balance sheet that has more reserves than are
theoretically necessarily? Okay, what's so bad about that?
Speaker 2 (10:26):
You're very existential?
Speaker 1 (10:27):
No, for real, Like I've heard this before. They want
to get it right. But like from an actual when
we think about the fed's goals, right, which is ultimately
and you describe it, it's about transmitting policy, these dual
mandids and all this stuff. What is the cost from
the Fed's purpose, It's raised on det of running having
a few extra these tokens on the system.
Speaker 2 (10:47):
Why are we here, Joe Joe one?
Speaker 1 (10:49):
Well, because because if we need to switch to X
because we want to get a better read on the
efficiency of our balance sheet. That implies that balance sheet
efficiency is an important thing.
Speaker 3 (11:01):
So I agree with you. I'm personally not opposed to
a big balance sheet. I would argue that having plenty
of reserves in the system increases the safety of banks, right,
they have more liquidity, that particular type of liquidity is
(11:21):
immediately available, right, because bank reserves can be accessed immediately,
whereas monetizing treasuries requires either repoeing them, going to the
discount window or selling them in the market. So ample
is probably where you should be targeting. An inefficient balance
(11:42):
sheet would be one where you could argue that banks
are overstocked with reserves, and because they're overstocked with reserves,
the cost of those reserves for them is low, and
anything that's low in price, you have an incentive to
(12:02):
hold more than you probably need. So from an efficiency argument,
you might argue that banks, because they've been oversupplied with
bank reserves, their demand for those reserves is excessive and
they should be holding, you know, kind of more treasuries
and other assets. The other example of this is if
you have a loaded federal reserve balance sheet right during
(12:25):
for example, QE, right, you create other sorts of distortions
in the market. So during QE, what we saw was
that bank demand for loans or loan demand was weak, right,
and the FED was pushing all these reserves into the system.
Banks ended up with lots and lots of deposits. These
deposits were uninsured, right, and they were very rate sensitive,
(12:50):
so that when the FED began raising interest rates, that
cash left very quickly, as in March of twenty three.
At the same time time, the cash on their balance
sheet was crowding out their fixed amount of capital, right,
So you were basically holding more cash than you wanted
(13:10):
to and you were rolling it into securities because loan
demand wasn't there, and so you had a balance sheet
that became more heavily skewed toward. This is the banks
skewed toward treasuries, lots of cash, and more flight prone liabilities.
So when the Fed began raising interest rates, everything became
(13:33):
unglued or became more volatile.
Speaker 2 (13:36):
There was also I think a populist component for a
time where people used to get upset that like the
foreign banks were earning lots of interest on their reserves
and things like that.
Speaker 3 (13:45):
Do you remember I do. I actually remember even earlier
than that, where there was work done about who was
benefiting from the liquidity programs in the financial crisis, and
there were in fact some newsagents he's filing Freedom of
Information Act requests to find out exactly who used what
(14:05):
facility and how much.
Speaker 2 (14:20):
Okay, I have to ask why the tri party rate
and not something like SOFUR the secured overnight financing rate,
which I thought, you know, that's supposed to be the
de facto benchmark money market rate, the one that replaced libor.
Speaker 1 (14:35):
That's right.
Speaker 3 (14:36):
I think the main distinction is because the triparty rate
or the triparty market itself, is a pure financing market.
It's the market in which the dealer community is raising
cash from cash providers like money market funds. By contrast,
SOFA is a little bit broader because it includes the
bilateral repo market. Because it includes the bilateral repo market.
(14:58):
That's more of a market where people are looking for
financing as well as specific q SIPs or specific treasury securities,
so they may have the left shoe, but they're looking
for the right shoe right. And because of that, you
basically have two different equilibria in the market. You have
(15:20):
a triparty equilibrium and then you have a SOFUR bilateral equilibrium.
And what Lori Logan was arguing is that that creates
kind of a bifurcated distribution where the incentives to trade
in one market may not be the same as in
the other, more smaller triparty market. The result is that
you may be you know, looking at at an average
(15:45):
or a volume weighted media across all of these markets
that doesn't actually reflect what's going on in the market.
Speaker 1 (15:52):
So what is the prospect of something fundamental changing and
what the FED targets? Okay, Lori Logan gives a speech,
but that's just a speech. And then if there were
going to be some change in what instrument or what
measured the FED targets, what are the technical challenges with
the new implementation.
Speaker 3 (16:09):
So the short answer to that is, I don't know.
What I would say is that my sense is that
it's probably sooner than people think. Lorie Logan has given
her past career at the New York FED and the
SOMA or the kind of the implementation desk at the
FED probably has a lot of weight in terms of
how the mechanics of monetary policy run. As far as
(16:32):
the other members of the FMC, I'm not sure what
their opinions are because nobody's really discussed this in the past.
So I would say that probably sooner rather than later.
But something that's not going to happen, you know, let's
say within the next two years. Okay, Mechanically you know
there have been certainly in my career, the FED has
(16:56):
you know, targeted the FED funds rate for the entire
period of time. I'm but the way it communicates what
it's targeting has changed. So when I started, the FED
used to do daily operations and what kind of daily
liquidity operation. There were fine distinctions between them that would
(17:17):
indicate how much the FED was expecting the FED funds
rate to move up or down. Then in ninety four,
you know, they basically came out and said that we're
going to target the rate itself. And then after that
and I think it was ninety five, they actually started
publishing the target rate in the FMC minut.
Speaker 1 (17:37):
Because it used to just be you had to you
would just into it right, it would just it would
arrive there and then they would figure out what the
target was.
Speaker 3 (17:44):
Yeah, they used to use expressions like expected to put
modest pressure on reserve conditions.
Speaker 1 (17:51):
Or because the FED has such a track record of
successfully targeting a rate, has that reduced the pressure to
actually trade in the market because word is so good.
Speaker 3 (18:03):
I'm going to say no. I think that the reason
there's no trading in the FED funds market partly as
I said earlier, is that, you know, because it's a
Roman lake of sorts, it's kind of a negotiated interest rate.
It's not really a traded rate.
Speaker 1 (18:18):
But I mean what I mean is like, does the
Fed does it not need to intervene directly as much
the way it did in the old days because everybody
knows that it can achieve it, and so the market
will take care of any deviations.
Speaker 3 (18:30):
Yes, I think that's partly true. I think that you know,
that was originally the reason why they had a band
around the target, because they weren't sure in two thousand
and eight that they could achieve that. In the subsequent years, yes,
they've kind of eliminated the fine tuning that they would
(18:51):
need to do to get the FED funds right to
the target.
Speaker 2 (18:54):
Okay, on the topic of nebulous FED words though, whether
it's modest or something like, ample reserves in the system
are still ample, but they are also falling. And meanwhile,
we've seen some repo rates going up recently. We had
the September fifteenth tax day, I guess September thirtieth quarter end,
(19:16):
there was a lot of concern that we might get,
you know, some sort of repo apocalypse as we used
to call it. That hasn't really materialized. But would you say,
overall the price of liquidity is going up.
Speaker 3 (19:28):
Yes, I totally agree with that. So reserves may be
ample at the moment, but their price is going up
because the amount of that ampleness is getting smaller and smaller.
And their variety of reasons why it's getting smaller and smaller.
One of them is QT. The other was the resolution
of the debt ceiling, which you know encouraged the Treasury
(19:49):
to kind of target a higher cash balance for precautionary reasons.
There was a speech recently by Hunter McMaster about what
the treasuries can balance target or goal or desired level is,
which is five to seven days of expected outflows. And
so they want to maintain an ample balance in their
(20:10):
checking account. But the Treasury's checking account is held at
the Federal Reserve, and that acts as a liability for
the FED, so it drains reserves as the balance goes up.
So all of these factors have kind of been moving,
and up until now, most of the decline in the
Fed's balance sheet is shown up as a shift out
(20:31):
of the reverse repo program, which is meant to mop
up excess reserves and the Treasury's account. Now what's happening
is that there's nothing left in the RP program, and
as the balance sheet shrinks further, it comes out of reserves.
As it comes out of reserves, the effect is kind
(20:52):
of disproportionate, if you will. Most of the reserve loss
that we've seen has come from foreign banks. Foreign banks
are the ones who are trading in the Fed funds market,
so their cost of liquidity is going up, right there,
bargaining power in this, you know, negotiation has deteriorated and
they have to pay an extra basis point. That's what
(21:14):
we've seen in recent days.
Speaker 1 (21:16):
Last question for me, you've seen any interesting have any
interesting thoughts these days about stable coins or how that
interacts with some of these markets.
Speaker 3 (21:23):
So the idea behind the stable coins as a payment mechanism,
right that they look similar to a money market fund,
and because they're similar in structure to a money market fund,
the idea is that they would have to buy short
duration assets, right, they'd have to buy treasure repo, they
(21:43):
have to buy treasury bills. So the goal or the
intent is that if demand for stable coins goes up,
the demand for bills will go up, and therefore the
treasure will find a new buyer for treasury bills, and
it could issue more treasure bills without pushing interest rates up. Right,
And if your goal hypothetically is to increase bill supply
(22:10):
but reduce the supply of term debt in order to
keep term interest rates from rising, then you need a
new large buyer of treasury bills. Right. That buyer theoretically
could be stable coins or at least a payment token
of some sort. The problem, of course, is that when
(22:33):
the demand for payment tokens goes up, it's taking away
from the demand of some other instruments that people use
for making payments deposits, credit cards, and paper currency. So
my sense, at least from looking at this and having
(22:55):
thought about it somewhat, is I think of the payment
tokens as a closer substitute for currency than a you know,
than a bank deposit. If you think about currency generally, right,
there's I think the average on person currency amount is
(23:18):
about sixty dollars, but per capita currency in the US
is something like seven thousand dollars or more. So there's
a significant volume of US currency that's held offshore, right,
some estimates between five eighth five eighths of US currency
is held offshore. There are nineteen billion one hundred dollars
(23:38):
bills out.
Speaker 1 (23:39):
There, nineteen billion one hundred dollars bills, Yes, so none
of them, No, I have a feel really yeah for
the less, if I played Pokemon.
Speaker 2 (23:47):
You keep them in your wallet.
Speaker 1 (23:48):
I have them in my bedside drawer.
Speaker 3 (23:50):
So you're part of the exception rather than the rule.
But my point being that a payment token, probably the
demand for it may be higher outside the US than
inside the US, because you have revolt lots of ways
of making fast payments. Where it might be more attractive
is in underbanked economies that are able to access mobile phones,
(24:15):
and so all things being equal, you could say it
is a substitute for the one hundred dollars bill, is
a store of value and a unit of account. And
in that case then you could potentially see strong demand
for payment tokens, but they would be located outside the US.
The other area would be with respect to remittances, so
sending money abroad again much easier to do with a
(24:38):
payment token. Making purchases theoretically using your credit card in
a non US currency sometimes can get hard, partly because
of anti fraud and other mechanisms. If you use the
stable coin, that might be easier. But the problem, of
course is that a stable coin used in that way
(25:00):
is just like using money right or paper money right.
Once it's gone right, you can't call your credit card
company and say stop that payment.
Speaker 2 (25:10):
I'm going to squeeze in. One more question on swap spreads,
which was actually the original reason why I reached out
to you, but then Lori Logan made her speech and
we got very distracted. But swap spreads, there's something going
on there, which is they seem to be widening, not
just in the US, but basically all around the world,
so Australia, Japan, Canada. I think what is going on there?
(25:34):
And why should we care about swap spreads?
Speaker 3 (25:37):
So I'm not an expert on swap spreads, but I
will say is that there's a general global theme about
fiscal prudence, if you will, and that the amount of
government debt outstanding is increasing and doesn't seem to be
going anywhere but up. The result of that is that
(25:58):
people demand a premium for holding that government debt. And
that's what we're seeing here, which is that that premium
has started to rise. Now. Initially in the US, the
sense was that after the certainly in April of this year,
that premium was expected to be higher. But I think
what happened in the US was that people recognize that
(26:21):
the deterioration in the fiscal outlook was not a unique
US phenomena, right, It was occurring across the board, certainly
in the countries, among the countries that you were mentioning.
So I think there's a I don't want to call
it bond vigilanteism, because I don't think that's what's going on,
but there is a realization that fiscal policy is moving
(26:44):
in presumably an unsustainable direction.
Speaker 2 (26:47):
Although weirdly the UK one hasn't moved that much.
Speaker 1 (26:51):
Yeah, I know, they got so much excitement at the
beginning of September and then it's been kind of chill.
Speaker 2 (26:55):
Yeah, Well, we'll see what happens. Lots More is produced
by Carmen Rodriguez and Dashel Bennett, with help from Moses
Ondam and Cal Brooks.
Speaker 1 (27:07):
Our sound engineer is Blake Maples. Sage Bauman is the
head of Bloomberg Podcasts.
Speaker 2 (27:12):
Please rate, review, and subscribe to ad lots and lots
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Speaker 1 (27:18):
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Speaker 2 (00:07):
Joe one and Joe two. I always wait, yeah, I
have to remember that. Well, you can answer whenever you want.
Speaker 1 (00:13):
Okay, that sounds good, all right, I might just sit
back with this one. I might just listen to the
I might just listen to Joe's answers and then listen
to your questions, which would be better than mine. I
did a deadlist.
Speaker 2 (00:25):
I'm both the most popular trader and most successful trader
at Citadel that.
Speaker 1 (00:30):
Is going viral.
Speaker 2 (00:31):
H barges.
Speaker 1 (00:32):
This is an after school special, except I've.
Speaker 2 (00:34):
Decided I'm going to base my entire personality going forward
on campaigning for a strategic pork reserve in the US.
Speaker 1 (00:40):
Black goals.
Speaker 2 (00:41):
These are the important questions that robots taking over the world.
Speaker 1 (00:44):
No, I think that like in a couple of years,
the AI will do a really good job of making
the odd Launch podcast. One day that person will have
the mandate of Heaven.
Speaker 2 (00:53):
How do I get more popular and successful?
Speaker 1 (00:56):
We do have Welcome to lots More, where we catch
up with friends about what's going.
Speaker 2 (01:02):
On right now, because even when Odd Lots is over,
there's always lots More.
Speaker 1 (01:07):
And we really do have the perfect guest.
Speaker 2 (01:13):
I think we've been lying to our listeners and our viewers.
Speaker 1 (01:16):
Go on, this is intriguing.
Speaker 2 (01:18):
We keep saying the FED is raising or lowering interest rates.
Speaker 1 (01:21):
Yeah, oh, I like this. I see, I already see
where you're going with this.
Speaker 2 (01:24):
But actually there's this whole constellation of rates, and we
will never really specify which one.
Speaker 1 (01:31):
It's less of a lie, more of an omission, et cetera.
It is true, especially at the short term level, that
there are all these different rates and they sort of
get abstracted away because I guess they can be arbed
one way if there's between the two, if they ever deviate,
So the FED can influence these other rates, and obviously
generally strongly does, but there's no guarantee that all these
(01:53):
short term rates always converge identically.
Speaker 2 (01:55):
No, And we have seen, for instance, instances where the
market rates have gone on far far outside what the
FED is actually targeting. So I should just say when
the FED raises or lowers interest rates, it does it
through well, it targets the FED funds, right, Yeah, okay,
and I think everyone has heard of that. But the
way it mechanically does it has changed over time. In fact,
(02:18):
it changed in a pretty big way early on in
our financial journalistic careers, so we should definitely talk about it.
Who's the guy that we call when we want to
talk money markets and mechanics of interest rates go on,
It's Joe Abatte.
Speaker 1 (02:31):
I'm really excited.
Speaker 2 (02:32):
So Joe has actually left Barclay's after more than twenty
eight years and he's now at SMBC NICO. He's head
of macro Strategy, so we're looking forward to hearing even
more from him. Joe talk to us about how the
actual mechanics of raising changing rates has changed over time.
Speaker 3 (02:51):
So originally, the FED started with a scarce reserve regime,
and the idea was that the level of liquidity in
the system was kept a little bit short of what
banks really wanted to hold, and that created a little
bit of torque in this interbank market, the FED funds market,
and that allowed the FED to move the Fed Funds
(03:13):
rate to exactly where it wanted to set the target,
and the target was set at a pinpoint level of
interest rates. Over time, and certainly beginning in about two
thousand and eight, the FED shifted to a different format,
and in that format, the FED would supply an ample
(03:33):
or abundant level of reserves and let the Fed Funds rate,
you know, trade or at least, in this case, not
trade at some spread or band between an upper and
lower band where it set the target. And originally it
set the target range ban because it wasn't confident that
this new structure would keep the Fed funds rate close
(03:56):
to a pinpoint level. But if you supply an abundant
level of reserves into the system, what happens is the
Fed funds market changes fundamentally, it adapts, it adapts, and
as it adapted, what happened was banks stopped trading in
the Fed funds market. They didn't need to borrow reserves
(04:17):
anymore because there's because there were plenty exactly. So the
market kind of devolved into basically an interest rate arbitrage.
You have one set of borrowers and one set of lenders.
The borrowers in this market are generally non US banks
and the lenders are the home loan banks. And the
(04:39):
reason there's this distinction is because the home loan banks
can't earn interest on their reserve on their cash balances
at the FED, so they have an incentive to sell
their cash right into the FED funds market to non
US banks. We're simply making the spread between FED funds
(05:00):
an IRB and in an ample reserve IRB oh interest
on reserve reserve balances. And that spread has been very,
very stable for the last probably four years or so
at minus seven bases points because the Fed's been operating
(05:20):
in an abundant reserve regime. The abundant reserve regime first
came about because of QWI, right, So you expanded the
Fed's balance sheet, created all these reserves, so banks were
overstuffed with liquidity.
Speaker 1 (05:34):
I'm going to ask a question that's going to sound
very negative, but it's not. It's actually I mean it
very literally because I think this might help us understand
why we're having this conversation. Who cares?
Speaker 3 (05:45):
Who cares about these.
Speaker 1 (05:47):
Any of this? And I do, and again I do
not mean this in the like a dismissive way. I
mean all of these things, like these short term things
that basically are equivalent, they could be away. The FED
seems to have a lot of control over these marks
gets in the end, even if it's not targeting one
or the other, the short term interest rate is basically
where the FED wants it. By any of these measures.
(06:09):
So literally, who cares about the plumbing?
Speaker 3 (06:12):
So the reason I think care about the plumbing is
that the FED uses it to communicate its policy intentions.
So it needs some sort of barometer, some sort of
measure for the market to be able to interpret what
the Fed's intentions are. So there's a twofold implication, if
you will, for the Fed funds market. One is the
(06:33):
FED uses the Fed Funds rate to communicate its policy intentions,
so raising rates, lowering rates, And it uses the dot plot,
for example, defined as the FED funds rate to provide
forward guidance to tell the market how far we're going
or what we see as the endgame potentially for interest rates.
(06:55):
And the second element is kind of more of a
mechanical one, which you're from to is the plumbing, which
is how does the Fed's intentions get translated into bank
deposit rates, mortgage rates, etc. Right. And one way to
think about this is that all of these term interest rates,
(07:16):
tenure yields, et cetera. Are all a reflection of what
you're expected. Path of the Fed is right defined as
Fed funds plus some premium right to reflect the term
risk that you're taking or inflation risk, et cetera. And
therefore there's a linkage between the overnight rates, the communication
(07:36):
of policy, and how it's transmitted to the broader financial
market system.
Speaker 2 (07:43):
I do think in terms of signaling the central bank's actions,
it is kind of funny that, you know, we're so
used to thinking of the Federal Reserve as a very
targeted institution, but when we're talking about reserves, the language
they use is like excess, abundant, yample, and there's no
hardcore definition of what those actually are. But I should
just say, the reason we were talking about this is
(08:05):
because everyone in money markets is talking about this right
now because Lori Logan at the Dallas FED, she did
a speech last week and a paper I think, basically
saying that the US the FED should move away from
targeting FED funds and look at some different ways of
targeting rates. Basically, was that a surprise to you when
(08:26):
you read the speech?
Speaker 3 (08:28):
It was a little bit of a surprise, since we
didn't really think that the Fed was preparing to actually
change policy rates. But the overall reasons for why they
might have to move away from a FED funds target
are pretty well known. So again, as I described the
Fed funds market earlier. Right, you've got one set of borrowers,
(08:50):
one set of lenders. It's become kind of a Roman lake. Right.
The provinces around the Mediterranean Wall spoke Latin. So in
a effect, there's not a lot of activity going on
between the FED funds market or the reason to borrow,
So it just becomes a communications device. So if you
(09:12):
move to a different barometer, let's say a triparty repo rate,
we can go into details about what exactly that means.
Speaker 2 (09:19):
So one that would be based on an active market.
Speaker 3 (09:21):
Correct, you would get not only the communications element, but
you'd also get a feedback on how well the FED
is doing and managing liquidity. Now, if reserves are always abundant,
I don't really need that information, right, I know that
reserves are abundant. But if I want to run an
efficient balance sheet for the FED, in other words, one
(09:45):
that's not any larger than it needs to be to
control interest rates, then I have to kind of bring
down the level of reserves in the system and monitor
as I bring down the level of reserves. What's happening
with liquidity in the overall system? Is it, as you said,
is it staying within the bands or is it moving
outside those bands and creating other sorts of distortions. And
(10:09):
that's why I need, hopefully a market traded instrument, and
that would be in this case the repo rate.
Speaker 1 (10:16):
What is the cost of running an inefficient balance sheet
or a balance sheet that has more reserves than are
theoretically necessarily? Okay, what's so bad about that?
Speaker 2 (10:26):
You're very existential?
Speaker 1 (10:27):
No, for real, Like I've heard this before. They want
to get it right. But like from an actual when
we think about the fed's goals, right, which is ultimately
and you describe it, it's about transmitting policy, these dual
mandids and all this stuff. What is the cost from
the Fed's purpose, It's raised on det of running having
a few extra these tokens on the system.
Speaker 2 (10:47):
Why are we here, Joe Joe one?
Speaker 1 (10:49):
Well, because because if we need to switch to X
because we want to get a better read on the
efficiency of our balance sheet. That implies that balance sheet
efficiency is an important thing.
Speaker 3 (11:01):
So I agree with you. I'm personally not opposed to
a big balance sheet. I would argue that having plenty
of reserves in the system increases the safety of banks, right,
they have more liquidity, that particular type of liquidity is
(11:21):
immediately available, right, because bank reserves can be accessed immediately,
whereas monetizing treasuries requires either repoeing them, going to the
discount window or selling them in the market. So ample
is probably where you should be targeting. An inefficient balance
(11:42):
sheet would be one where you could argue that banks
are overstocked with reserves, and because they're overstocked with reserves,
the cost of those reserves for them is low, and
anything that's low in price, you have an incentive to
(12:02):
hold more than you probably need. So from an efficiency argument,
you might argue that banks, because they've been oversupplied with
bank reserves, their demand for those reserves is excessive and
they should be holding, you know, kind of more treasuries
and other assets. The other example of this is if
you have a loaded federal reserve balance sheet right during
(12:25):
for example, QE, right, you create other sorts of distortions
in the market. So during QE, what we saw was
that bank demand for loans or loan demand was weak, right,
and the FED was pushing all these reserves into the system.
Banks ended up with lots and lots of deposits. These
deposits were uninsured, right, and they were very rate sensitive,
(12:50):
so that when the FED began raising interest rates, that
cash left very quickly, as in March of twenty three.
At the same time time, the cash on their balance
sheet was crowding out their fixed amount of capital, right,
So you were basically holding more cash than you wanted
(13:10):
to and you were rolling it into securities because loan
demand wasn't there, and so you had a balance sheet
that became more heavily skewed toward. This is the banks
skewed toward treasuries, lots of cash, and more flight prone liabilities.
So when the Fed began raising interest rates, everything became
(13:33):
unglued or became more volatile.
Speaker 2 (13:36):
There was also I think a populist component for a
time where people used to get upset that like the
foreign banks were earning lots of interest on their reserves
and things like that.
Speaker 3 (13:45):
Do you remember I do. I actually remember even earlier
than that, where there was work done about who was
benefiting from the liquidity programs in the financial crisis, and
there were in fact some newsagents he's filing Freedom of
Information Act requests to find out exactly who used what
(14:05):
facility and how much.
Speaker 2 (14:20):
Okay, I have to ask why the tri party rate
and not something like SOFUR the secured overnight financing rate,
which I thought, you know, that's supposed to be the
de facto benchmark money market rate, the one that replaced libor.
Speaker 1 (14:35):
That's right.
Speaker 3 (14:36):
I think the main distinction is because the triparty rate
or the triparty market itself, is a pure financing market.
It's the market in which the dealer community is raising
cash from cash providers like money market funds. By contrast,
SOFA is a little bit broader because it includes the
bilateral repo market. Because it includes the bilateral repo market.
(14:58):
That's more of a market where people are looking for
financing as well as specific q SIPs or specific treasury securities,
so they may have the left shoe, but they're looking
for the right shoe right. And because of that, you
basically have two different equilibria in the market. You have
(15:20):
a triparty equilibrium and then you have a SOFUR bilateral equilibrium.
And what Lori Logan was arguing is that that creates
kind of a bifurcated distribution where the incentives to trade
in one market may not be the same as in
the other, more smaller triparty market. The result is that
you may be you know, looking at at an average
(15:45):
or a volume weighted media across all of these markets
that doesn't actually reflect what's going on in the market.
Speaker 1 (15:52):
So what is the prospect of something fundamental changing and
what the FED targets? Okay, Lori Logan gives a speech,
but that's just a speech. And then if there were
going to be some change in what instrument or what
measured the FED targets, what are the technical challenges with
the new implementation.
Speaker 3 (16:09):
So the short answer to that is, I don't know.
What I would say is that my sense is that
it's probably sooner than people think. Lorie Logan has given
her past career at the New York FED and the
SOMA or the kind of the implementation desk at the
FED probably has a lot of weight in terms of
how the mechanics of monetary policy run. As far as
(16:32):
the other members of the FMC, I'm not sure what
their opinions are because nobody's really discussed this in the past.
So I would say that probably sooner rather than later.
But something that's not going to happen, you know, let's
say within the next two years. Okay, Mechanically you know
there have been certainly in my career, the FED has
(16:56):
you know, targeted the FED funds rate for the entire
period of time. I'm but the way it communicates what
it's targeting has changed. So when I started, the FED
used to do daily operations and what kind of daily
liquidity operation. There were fine distinctions between them that would
(17:17):
indicate how much the FED was expecting the FED funds
rate to move up or down. Then in ninety four,
you know, they basically came out and said that we're
going to target the rate itself. And then after that
and I think it was ninety five, they actually started
publishing the target rate in the FMC minut.
Speaker 1 (17:37):
Because it used to just be you had to you
would just into it right, it would just it would
arrive there and then they would figure out what the
target was.
Speaker 3 (17:44):
Yeah, they used to use expressions like expected to put
modest pressure on reserve conditions.
Speaker 1 (17:51):
Or because the FED has such a track record of
successfully targeting a rate, has that reduced the pressure to
actually trade in the market because word is so good.
Speaker 3 (18:03):
I'm going to say no. I think that the reason
there's no trading in the FED funds market partly as
I said earlier, is that, you know, because it's a
Roman lake of sorts, it's kind of a negotiated interest rate.
It's not really a traded rate.
Speaker 1 (18:18):
But I mean what I mean is like, does the
Fed does it not need to intervene directly as much
the way it did in the old days because everybody
knows that it can achieve it, and so the market
will take care of any deviations.
Speaker 3 (18:30):
Yes, I think that's partly true. I think that you know,
that was originally the reason why they had a band
around the target, because they weren't sure in two thousand
and eight that they could achieve that. In the subsequent years, yes,
they've kind of eliminated the fine tuning that they would
(18:51):
need to do to get the FED funds right to
the target.
Speaker 2 (18:54):
Okay, on the topic of nebulous FED words though, whether
it's modest or something like, ample reserves in the system
are still ample, but they are also falling. And meanwhile,
we've seen some repo rates going up recently. We had
the September fifteenth tax day, I guess September thirtieth quarter end,
(19:16):
there was a lot of concern that we might get,
you know, some sort of repo apocalypse as we used
to call it. That hasn't really materialized. But would you say,
overall the price of liquidity is going up.
Speaker 3 (19:28):
Yes, I totally agree with that. So reserves may be
ample at the moment, but their price is going up
because the amount of that ampleness is getting smaller and smaller.
And their variety of reasons why it's getting smaller and smaller.
One of them is QT. The other was the resolution
of the debt ceiling, which you know encouraged the Treasury
(19:49):
to kind of target a higher cash balance for precautionary reasons.
There was a speech recently by Hunter McMaster about what
the treasuries can balance target or goal or desired level is,
which is five to seven days of expected outflows. And
so they want to maintain an ample balance in their
(20:10):
checking account. But the Treasury's checking account is held at
the Federal Reserve, and that acts as a liability for
the FED, so it drains reserves as the balance goes up.
So all of these factors have kind of been moving,
and up until now, most of the decline in the
Fed's balance sheet is shown up as a shift out
(20:31):
of the reverse repo program, which is meant to mop
up excess reserves and the Treasury's account. Now what's happening
is that there's nothing left in the RP program, and
as the balance sheet shrinks further, it comes out of reserves.
As it comes out of reserves, the effect is kind
(20:52):
of disproportionate, if you will. Most of the reserve loss
that we've seen has come from foreign banks. Foreign banks
are the ones who are trading in the Fed funds market,
so their cost of liquidity is going up, right there,
bargaining power in this, you know, negotiation has deteriorated and
they have to pay an extra basis point. That's what
(21:14):
we've seen in recent days.
Speaker 1 (21:16):
Last question for me, you've seen any interesting have any
interesting thoughts these days about stable coins or how that
interacts with some of these markets.
Speaker 3 (21:23):
So the idea behind the stable coins as a payment mechanism,
right that they look similar to a money market fund,
and because they're similar in structure to a money market fund,
the idea is that they would have to buy short
duration assets, right, they'd have to buy treasure repo, they
(21:43):
have to buy treasury bills. So the goal or the
intent is that if demand for stable coins goes up,
the demand for bills will go up, and therefore the
treasure will find a new buyer for treasury bills, and
it could issue more treasure bills without pushing interest rates up. Right,
And if your goal hypothetically is to increase bill supply
(22:10):
but reduce the supply of term debt in order to
keep term interest rates from rising, then you need a
new large buyer of treasury bills. Right. That buyer theoretically
could be stable coins or at least a payment token
of some sort. The problem, of course, is that when
(22:33):
the demand for payment tokens goes up, it's taking away
from the demand of some other instruments that people use
for making payments deposits, credit cards, and paper currency. So
my sense, at least from looking at this and having
(22:55):
thought about it somewhat, is I think of the payment
tokens as a closer substitute for currency than a you know,
than a bank deposit. If you think about currency generally, right,
there's I think the average on person currency amount is
(23:18):
about sixty dollars, but per capita currency in the US
is something like seven thousand dollars or more. So there's
a significant volume of US currency that's held offshore, right,
some estimates between five eighth five eighths of US currency
is held offshore. There are nineteen billion one hundred dollars
(23:38):
bills out.
Speaker 1 (23:39):
There, nineteen billion one hundred dollars bills, Yes, so none
of them, No, I have a feel really yeah for
the less, if I played Pokemon.
Speaker 2 (23:47):
You keep them in your wallet.
Speaker 1 (23:48):
I have them in my bedside drawer.
Speaker 3 (23:50):
So you're part of the exception rather than the rule.
But my point being that a payment token, probably the
demand for it may be higher outside the US than
inside the US, because you have revolt lots of ways
of making fast payments. Where it might be more attractive
is in underbanked economies that are able to access mobile phones,
(24:15):
and so all things being equal, you could say it
is a substitute for the one hundred dollars bill, is
a store of value and a unit of account. And
in that case then you could potentially see strong demand
for payment tokens, but they would be located outside the US.
The other area would be with respect to remittances, so
sending money abroad again much easier to do with a
(24:38):
payment token. Making purchases theoretically using your credit card in
a non US currency sometimes can get hard, partly because
of anti fraud and other mechanisms. If you use the
stable coin, that might be easier. But the problem, of
course is that a stable coin used in that way
(25:00):
is just like using money right or paper money right.
Once it's gone right, you can't call your credit card
company and say stop that payment.
Speaker 2 (25:10):
I'm going to squeeze in. One more question on swap spreads,
which was actually the original reason why I reached out
to you, but then Lori Logan made her speech and
we got very distracted. But swap spreads, there's something going
on there, which is they seem to be widening, not
just in the US, but basically all around the world,
so Australia, Japan, Canada. I think what is going on there?
(25:34):
And why should we care about swap spreads?
Speaker 3 (25:37):
So I'm not an expert on swap spreads, but I
will say is that there's a general global theme about
fiscal prudence, if you will, and that the amount of
government debt outstanding is increasing and doesn't seem to be
going anywhere but up. The result of that is that
(25:58):
people demand a premium for holding that government debt. And
that's what we're seeing here, which is that that premium
has started to rise. Now. Initially in the US, the
sense was that after the certainly in April of this year,
that premium was expected to be higher. But I think
what happened in the US was that people recognize that
(26:21):
the deterioration in the fiscal outlook was not a unique
US phenomena, right, It was occurring across the board, certainly
in the countries, among the countries that you were mentioning.
So I think there's a I don't want to call
it bond vigilanteism, because I don't think that's what's going on,
but there is a realization that fiscal policy is moving
(26:44):
in presumably an unsustainable direction.
Speaker 2 (26:47):
Although weirdly the UK one hasn't moved that much.
Speaker 1 (26:51):
Yeah, I know, they got so much excitement at the
beginning of September and then it's been kind of chill.
Speaker 2 (26:55):
Yeah, Well, we'll see what happens. Lots More is produced
by Carmen Rodriguez and Dashel Bennett, with help from Moses
Ondam and Cal Brooks.
Speaker 1 (27:07):
Our sound engineer is Blake Maples. Sage Bauman is the
head of Bloomberg Podcasts.
Speaker 2 (27:12):
Please rate, review, and subscribe to ad lots and lots
more on your favorite podcast platforms.
Speaker 1 (27:18):
And remember that Bloomberg subscribers can listen to all of
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for listening.
Hosts And Creators
Joe Weisenthal
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