Editor’s Note: We’re sharing this Wall Street Examiner with you today because no one else is looking at the real interest rate story right now: short-term commercial paper. While the media focuses on the fed funds rate, hikes in this critical market have brought us to the edge of an unprecedented liquidity crunch. Here’s Lee…
Wall Street and the media breathlessly waited for Yellen & Co. to hike the fed funds target from 0% to 0.25% up to 0.25% to 0.50% – a move that’s been telegraphed for months and largely already priced in to the ZIRP-addled markets.
The drama around this move was manufactured. You can’t call those rates anything but accommodative.
But with so much focus on the fed funds rate, it’s really not surprising that the media missed the fact that the really important rates have been on the move since July.
Meanwhile, “overnight money,” money that the central bank loans overnight to banks (and which the Fed influences through open market operations), has barely budged.
We’re looking at a liquidity crunch like nothing we’ve ever seen before. Here’s how it happened and how bad it’s likely to get…
How We Got Here
It seems the fear of even a minuscule, one-off rate hike has become a self-fulfilling prophecy. There’s a vicious cycle underway right now and it will get even uglier before it’s all said and done.
You see, beginning in the second quarter, selling of leveraged instruments like commodities futures, leveraged emerging markets debt and equity bought on margin, and especially junk debt, began to cause liquidity to dry up.
Margin calls started to go out, which extinguished deposits and caused distress in the leveraged carry trades.
As the collapse in the junk market worsened, rates rose.
Most recently, junk debt hedge and mutual funds, like the Third Avenue Focused Credit Fund (MUTF: TFCVX) and others run by Stone Lion Capital Partners and Lucidus Capital Partners, have been inundated with redemption requests that they can’t easily honor. They’ve “gated” – they have cut investors off from their money and have essentially collapsed.
That means liquidity is about to get as scarce as water in the Sahara…
Commercial Paper Is Like a Bat Out of Hell Now
In effect, the market has already tightened. Signs of a money crunch are showing up in soaring money market rates in durations longer than overnight – remember, those rates haven’t moved. Now there are clear signs of turmoil even in maturities as short as seven days – and it looks worse at 30 and 90 days.
Various types of 30-day commercial paper, which big corporations use to meet their short-term debt obligations, like payroll, have risen almost 20 basis points since October and nearly 30 basis points since July. Ninety-day has moved even more: 25 to 30 basis points since October and 30 to 35 basis points since July.
The lack of rate increases in overnight paper and fed funds makes me believe the Fed will have serious trouble making a rate increase stick. It looks more and more like the Fed will not be able to prevent a spontaneous, self-generating market tightening from spiraling out of control.
When that happens, get ready for liquidity to dry up fast. Sellers won’t be able to sell, and buyers won’t buy… and prices will get downright chaotic.
This tightening has been exacerbated by something the U.S. Treasury did last month…
How the U.S. Treasury Made This Worse
The U.S. Treasury had been forced out of the market by the debt ceiling, and during September and October, it actually paid down $140 billion in debt. Thirty- and 90-day rates actually came down around 10 basis points at the time, as the Treasury pumped cash back into the accounts of dealers and other holders of T-bills that were expiring and not being rolled over.
Those holders moved their cash into other types of paper, which pushed rates down.
But in November, once the debt ceiling was lifted, the Treasury came to market with $310 billion in net new debt. As soon as the Treasury moved to claw back that cash and then some, the shortage of T-bills became a glut.
As the Treasury sold that $310 billion in new paper last month, it sucked cash out of the market. That action, along with turmoil in commodities, emerging markets, and junk debt, caused short-term interest rates to soar as the prices of collateral collapsed and calls for additional collateral went out.
So perhaps it really doesn’t matter that the Fed hiked the funds rate – the markets were already so addicted to ZIRP that the mere fear of rate increases caused them to come unglued.
As a result, liquidity available for carry trades has tightened, and rates for short-term money, where overnight money is not plentiful or even available, have already surged.
The Fed can’t do anything about that, but the turmoil may be enough to keep it from trying to move the fed funds rate any higher.
Either way, it will be “interesting.”
Read Lee Adler every day at The Wall Street Examiner.
Follow us on Twitter @moneymorning.
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