The Interbank Market News Scan: An arbitrage moment for U.S. banks

Morning thoughts …

When I listen to the YouTube posse opine about the Federal Reserve’s use of its monetary policy tools, I sense the gurus lack of awareness that they are playing in a sandbox and trying to navigate in the afterburn of an airplane engine.

The noise can be deafening. The clutter thicker than peanut butter. Money managers, traders and brokers are not aware that the paper market they trade in was created by government. When I listen to them opine on social and analog media, they give me the impression that the Federal Reserve, an agency that they pay too much attention to, is somehow trespassing on their turf. Actually, these money managers, traders, and brokers are trespassing on the central and commercial banks’ turf.

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The government produces tax liens, debt, and currency and sells these items into the paper markets for the purpose of raising revenues or manipulating the foreign exchange markets. Primary dealers package these items into securities and resell them to money managers and investors. These money managers and investors hope to either make money from the appreciation in the value of these securities or from the residuals these securities may generate i.e., dividends or coupon payments.

To ensure demand for its currency and the debt that it issues, the government needs other markets and sectors to create taxable revenues with part of the after-tax revenues reinvested into dollar-denominated securities. With all the talk and fear mongering about China, Russia, and other Asian, African, and South American countries creating an alternative set of resource-backed currencies, the U.S. government should focus on making the dollar attractive.

I believe in the long run that a scheme to increase the attractiveness of the dollar will include a return of more manufacturing jobs to American shores. Past American presidents have hinted at the need to not only promote college education but to energize the pursuit of vocational skills. If the U.S. is to grow its manufacturing base, a trained manufacturing labor force will be necessary.

The stats ….

Data from the Federal Reserve Bank of New York shows that the discount rate is at 4.75% while interest paid on reserve balances is at 4.65%. The discount rate reflects the rate at which primary credit bank customers can borrow from a federal reserve bank. The interest rate on reserve balances is paid on reserves held for depository institutions.

Meanwhile the effective federal funds rate is approximately 4.57%. This rate reflects the arithmetic average of the overnight rate assessed by banks that lend excess reserves in the fed funds overnight market. There appears to be an arbitrage opportunity here for banks to borrow in the fed funds market and deposit the funds in their reserve accounts thus taking advantage of the spread.

Traders and speculators are expecting at least a 25-basis point increase in the target range for the federal funds rate. The current range is 4.50 percent to 4.75 percent. Between October 2022 and January 2023, the personal consumption index has fallen from 6.1 percent to 5.4 percent. This slow-down in personal consumption may be giving the Board of Governors of the Federal Reserve System some pause from increasing the fed funds rate any higher than 25 basis points. The Bureau of Economic Analysis will issue its next PCE report on 31 March 2023.

Any thoughts as to where the PCE is going and how it will impact the Fed’s rate targeting might be shared this week during Jerome Powell’s report to Congress on the state of monetary policy.

The politics ….

As discussed earlier, Board of Governors of the Federal Reserve System chairman Jerome Powell delivers a report on monetary policy to Congress this week. On Tuesday, Chairman Powell delivers his report to the U.S. Senate Committee on Banking, Housing and Urban Affairs. On Wednesday, the Chairman will deliver his report to the U.S. House Committee on Financial Services. I expect members from both committees to key in on inflation and job growth given the Federal Reserve’s dual mandate of stable prices and full employment.

Chairman Powell has expressed that he will use all the Fed’s tools to get inflation down to two percent. Pundits have been warning that Chairman Powell’s focus on reining in inflation may mean a slowdown in the economy including a reduction in employment stemming from a reduction in consumer spending. The political fallout from Chairman Powell’s “all hands on deck” approach could be considerable. I expect members of both committees to telegraph fiscal policy and other political approaches to the potential fallout.

The law …

As of today, I see no proposed changes in U.S. law that will impact the interbank, federal funds, or fed funds futures market.

Alton Drew

5 March 2023

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