Currency of Mordor

More than a year ago the Fed had its first rate hike in more than a decade. The event will definitely be remembered as a milestone, however, it is yet hard to tell if it will mark the start of a firm recovery or something worse. Just remember the example of ’36; it was premature then, and given the still negative output gap, underemployment, and demographic changes this might be proved to be wrong too.

The monetary tightening started a bit before December of 2015 though. Prior to the historical hike, the Securities Exchange Commission (SEC) announced its planned reform regarding the operation of money market mutual funds, the USD 2.7 trillion sector, which is responsible for both internal and external interbank lending. According to the new regulations, money market mutual funds investing in non-government issued securities must change to floating NAV accounting (making it a bit more volatile to investors), and can use liquidity fees and redemption gates to prevent fund-runs.

The legal changes came into effect last October, however, markets always price in advance. Exactly a year before the implementation of the reform, preparing for tightening and for the reform, investors headed to the exit, and started to stockpile funds with T-bills. This raised borrowing costs on the interbank market (USD Libor), made currency swaps (Eurodollar, yen) costly, and widened the TED spread, sending small, but significant shockwaves through the markets. If you were preparing for the rate hike with floating instruments linked to Libor you could beat the market for 14 month now.

But why did Libor rates rise? If I buy the T-bill from an other investor know he will have to hold the liquidity, or buy something else, in which case his new partner will hold the money. It cannot disappear from the system this way.

Similarly to the One Ring in Tolkein’s epic tale, modern currencies can only be destroyed were they were born. In the depth of Mount Doom, in this case also known as the Fed’s vaults (or accounts, to be more precise). Given the role of dollar in international finance, I believe it is not inappropriate to say that this little change made many markets’ life harder, especially when the dollar was already increasing financing costs due to its appreciation.

One Ring to rule them all, One Ring to find them,
One Ring to bring them all and in the darkness bind them…

As this little story foreshadowed it, if you are interested in the where the money went you have to dig up the Fed’s balance sheet. In this period, when Libor started rising, and money flew from prime money funds, you will find two factors behind the tightening of liquidity. Firstly, banks entered into reverse repo agreements, obtaining government bonds from the Fed’s stock. Secondly, the government account drained bank liquidity (high powered money). Although, the latter doesn’t necessarily imply that the banks were given bonds in exchange, the effect is nonetheless the same. Interbank liquidity dries up.


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