Another Lesson in Supply and Demand

Money markets are again in turmoil, and once again it's hard to figure out exactly what's going on. However, the example I used back in September 2019 serves to explain things rather well this time too.

Back then, there was an effort by the Fed to keep interest rates low and withdraw liquidity at one and the same time, which is comparable to a warehouse deciding to lower prices while at the same time reducing supply. Naturally, this didn't work. Demand for credit exploded higher at the the very same time that supply was reduced, with dramatically higher interest rates in the overnight REPO market as a result.

Then we got the Covid plague just in time to rescue the Fed. Main Street demand for credit was crushed, and interest rates could be kept low for another year. Coupled with a flood of credit to Wall Street, all sorts of asset prices exploded higher while the average Joe was locked down at home, scared and confused.

But of late, interest rates at the long end have crept higher. People are increasingly reluctant to lend money for more than a few years to a government that spends money as if there's no tomorrow. This is problematic for an economy levered up to their eyeballs in debt. But something equally troubling is also happening at the short end. Overnight rates are about to go negative.

This latest development seems at first absurd. How can long rates go up and short rates go down at one and the same time? However, this too can be explained in terms of our warehouse once we recognize that this warehouse only serves the short end of the credit curve. It's an overnight facility, and as such it serves the sort of banks that the average Joe uses for his affairs. When Joe feels confident enough to borrow some money, banks go to the warehouse for cash. When Joe is more inclined to save, banks go to the warehouse to deposit their excess cash.

With Joe still reluctant to go out and borrow, stimulus money coming from the US treasury go directly into savings accounts. This cash is then handed over to the warehouse which tries its best to discourage this behaviour. Interest rates go down to the point of going negative. Joe has gone from overly confident to overly cautious, and the Fed is now trying to change his sentiment once again. But Joe is already in the grip of a manic depressed anxiety. This latest push will likely aggravate his condition further, and the net result may turn into a hyperinflationary melt down.

It appears that the Fed is once again close to the breaking point and only inches away from loosing control. What happens next is anyone's guess.

By U.S. Government - Extracted from PDF version of the Federal Reserve's Purposes & Functions document (direct PDF URL [1])., Public Domain, Link