We keep saying the Fed is raising or lowering interest rates. But actually, there's this whole constellation of rates and we never really specify which one.

It's less of a lie and more of an omission etc. It is true, especially at the short-term level that they're 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 it's no guarantee that all these short-term rates always converge identically.

No. And we have seen for instance instances where the market rates have gone 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 rate. Okay? And I think everyone has heard of that. But the way it mechanically does it has changed over time.

In fact, 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? It's Joe Abate.

Joe has actually left Barclays after more than 28 years and he's now at SMBC Nico. He's head of macro strategy. So, we're looking forward to uh hearing even more from him. Uh Joe, talk to us about how the actual mechanics of raising changing rates has changed over time.

So originally the Fed started with a scarce reserve regime and the idea was that the level of liquidity in the system was always 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 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 2008, the Fed shifted to a different format. And in that format, the Fed would supply an ample 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 band because it wasn't confident that this new structure would keep the Fed funds rate close 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 anymore because there were plenty there. 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 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 who are simply making the spread between Fed funds and IRB and in an ample reserve IRB oh interest on reserves okay reserve balances and that spread has been very very stable for the last probably four years or so at minus minus seven basis points because the Fed's been operating in an abundant reserve regime. The abundant reserve regime first came about because of QE, right? So, you expanded the Fed's balance sheet, created all these reserves, so banks were oversted with liquidity.

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? Who cares about the any of this? And I do and again I do not mean this in like a dismissive way. I mean all of these things like these short-term things that basically are equivalent. They could be armed away. The Fed seems to have a lot of control over these markets. 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. So literally, who cares about the plumbing?

So the reason you 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 two-fold implication, if you will, for the Fed funds market. One is the 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.

And the second element is kind of more of a mechanical one, which you're referring to as the plumbing. Yeah. 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, tenure yields, etc. are all a reflection of what your 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, etc. And therefore there's a linkage between the overnight rates, the communication of policy and how it's transmitted to the broader financial market system.

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 apple. And there's no hardcore definitions of what those actually are. But I should just say the reason we are talking about this is 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 you read the speech?

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, one set of lenders. It's become kind of a Roman lake, right? The provinces around the Mediterranean all spoke Latin. So in effect, right, 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 move to a different barometer, let's say a triparty repo rate, and we can go into details about what exactly that means. So, one that would be based on an active market, correct? You would get not only the communications element, but you'd also get a feedback on how well the Fed is doing in 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 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 that's why I need hopefully a market traded instrument and that would be in this case the repo rate.

What is the cost of running an inefficient balance sheet or a balance sheet that has more reserves than are theoretically necessary? Like okay, what's so bad about that? You're very existential to me. 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 described it, it's about transmitting policy, these dual mandates and all this stuff. What is the cost from the Fed's purpose? It's razone debt of running a having a few extra of these tokens in the system. Why are we here, Joe? Yeah, Joe one. Well, no, cuz like Yeah. No, 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.

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 immediately available, right? Because bank reserves can be accessed a immediately whereas monetizing treasuries requires either repoing them, going to the discount window or selling them in the market. So ample is probably where you should be targeting. An inefficient balance 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 hold more than you probably need. So from an efficiency argument, you might argue that banks because they've been over supplied 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 bloated Federal Reserve balance sheet, right, during, 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 so that when the Fed began raising interest rates that cash left very quickly as in March of 23. Mhm. At the same 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 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 flightprone liabilities. So when the Fed began raising interest rates, everything became unglued or became more volatile. 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. Do you remember? I 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 news agencies filing Freedom of Information Act requests to find out exactly who used what facility and how much.

Okay, I have to ask why the trip 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 Liebore.

That's right. 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, sofur is a little bit broader because it includes the bilateral repo market. And because it includes the bilateral repo market, that's more of a market where people are looking for financing as well as specific QIPS 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 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 a at an an average or a volume weighted median across all of these markets. that doesn't actually reflect what's going on in the market.

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 measure the Fed targets, you know, what are the technical challenges with the new implementation?

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. Lori Logan is given her past career at the New York Fed and the SOM or the, you know, 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 the other members of the FOMC, 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.

Mechanically, you know, there have been certainly in my career, the Fed has, you know, targeted the Fed funds rate for the entire period of time, 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 indicate how much the Fed was expecting the Fed funds rate to move up or down. Then in 94 you know they basically came out and said that we're going to target the rate itself. Mhm.

And then after that in I think it was '95 they actually started publishing the target rate in the FOMC minutes because it used to just be you had to you would just intuitive right it would just it would arrive there and then they would figure out what the target was. Yeah. Yeah. They used to use expressions like expected to put modest pressure on reserve conditions 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 the word is so good?

Uh I'm going to say no. I 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. But I mean the what I meant 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. 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 2008 that they could achieve that. in the subsequent years. Yes, they've kind of eliminated the fine-tuning that they would need to do to get the Fed funds rate to the target.

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. Uh we had the September 15th tax day. I guess September 30th quarter end. 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?

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 there are 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 to kind of target a higher cash balance for precautionary reasons. There was a speech recently by Hunter McMaster about what the Treasury's cash balance target or goal or desired level is, which is 5 to 7 days of expected outflows. And so they want to maintain an ample balance in their 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 has shown up as a shift out 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 RRP program and as the balance sheet shrinks further it comes out of reserves. as it comes out of reserves, the effect is kind 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? Their bargaining power in this, you know, negotiation has deteriorated and they have to pay an extra basis point and that's what we've seen in recent days.

Last question for me. you seen any interesting have any interesting thoughts these days about stable coins or how that interacts with some of these markets? So the idea behind the stable coins is 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 Treasury repo, they'd 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 treasury will find a new buyer for treasury bills and it could issue more treasury bills without pushing interest rates up, right? And if your goal hypothetically is to increase bill supply but reduce the supply of term debt in order to keep term interest rates from rising. Yeah. 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 the demand for payment tokens goes up, it's taking away from the demand other other instruments that people use for making payments. Yeah. Right. Deposits, right? Credit cards and paper currency. So my sense at least from looking at this and having 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 onperson currency amount is about $60, but per capita currency in the US is something like $7,000 or more. So there's a significant volume of US currency that's held offshore, right? Some estimates between 58 58 of US currency is held offshore. There are 19 billion $100 bills out there. 19 billion $100 bills? Yes. So, I have none of them. No, I have a few. Oh, really? Yeah. From the last time I played poker. Do you keep them in your wallet? I have them in my bedside drawer. 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 all lots of ways of making fast payments. Where it might be more attractive is in underbanked economies that are able to access mobile phones. And so all things being equal, you could say it is a substitute for the $100 bill as 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. Right. Right. So sending money abroad. Again much easier to do with a payment token. Making purchases theoretically using your credit card and a non US currency sometimes can get hard partly because of anti-fraud and other uh mechanisms. If you used a stable coin, that might be easier. But the problem, of course, is that a stable coin used in that way 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."

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? And why should we care about swap spreads?

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 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 recognized that the deterioration in the fiscal outlook was not a uni 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 in presumably an unsustainable direction. Although weirdly the UK one hasn't moved that much. Yeah, I know. They got so much excitement at the beginning of September and then it's uh it's been kind of chill. Yeah. Well, we'll see what happens.