The unprecedented amount of cash the Federal Reserve has pumped into the financial system is proving more powerful for money-market rates than Chair Janet Yellen's signals she will start turning off the spigot.
At a time when Treasury bond yields are climbing on speculation that Yellen will raise interest rates sooner than expected, the three-month London interbank offered rate is going the other way. The cost of three-month loans in dollars between banks, or Libor, fell to 0.22810 percent yesterday, setting a record low for the second straight day, according to the ICE Benchmark Administration in London.
Libor, a benchmark for more than $3 trillion of global contracts and loans, has fallen about 0.02 percentage point since the end of last year despite the Fed pulling back on its bond purchases and Yellen signaling she may raise borrowing costs next year. While yields on debt that matures in 2016 or later have increased, the shortest-term rates are sliding as investors search for a place to park their record amounts of cash and reduce interest-rate risk.
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"People have to put the money somewhere and in many respects interbank lending is safe now," said David Keeble, head of fixed-income strategy at Credit Agricole SA in New York. "So you have a supply of cash and a safe place to put it and this is just pushing everything lower."
Lending to banks is appealing as capital levels at financial institutions have improved since the 2008 financial crisis. The Fed said last week that the largest banks are better positioned to lend and meet their financial commitments, with its annual stress tests showing 29 of the 30 largest U.S. banks able to withstand a deep recession and still pay dividends.
The federal funds effective rate — the average daily market rate on overnight loans between banks — was 0.06 percent on March 31, compared with 0.16 percent on April 1, 2013. The Fed has held its target for the benchmark rate at zero to 0.25 percent since December 2008. Yellen said March 19 that policy makers may begin lifting their benchmark rate six months after they end their third round of bond buying.
While Yellen's remarks last month led traders to pull forward their bets for rising interest rates, the U.S. central bank is still adding to its stimulus and expanding the amount of cash in the financial system. The Fed's latest round of asset purchases pumped up its balance sheet to a record $4.23 trillion on March 26, up from $4.02 trillion on Jan. 1 and $2.3 trillion at the end of 2008.
Policy makers have cut their monthly debt buying by $10 billion increments at each of their last three meetings to $55 billion. They probably will continue with reductions at that pace and end the program in October, economists said in a Bloomberg News survey last month.
Growing Liquidity
The stimulus creates liquidity because the Fed buys securities from primary dealers, or brokers that are authorized to trade directly with the central bank, adding funds to their accounts and creating reserves at their clearing banks.
"Excess liquidity is just growing and growing," Keeble said. "It will keep marching higher probably until October, when the Fed finally stops its quantitative easing."
Money market mutual funds, which are among the primary users of short-term debt instruments, have seen assets rise over the last year as investors seek safer alternatives to stocks and bonds. Assets in prime money funds have climbed to $1.5 trillion as of March 25 from $1.46 trillion a year ago, according to data compiled by research firm iMoneyNet in Westborough, Massachusetts.
The U.S.'s successful introduction this year of floating-rate Treasury notes has shown investors' demand for alternative money-market securities to allocate their cash. The debt offers a way to hedge against higher interest rates, too.
The Treasury sold $13 billion of floaters on March 27 at a bid-to-cover ratio, which gauges demand by comparing the amount of bids with the amount of securities offered, of 4.67, higher than the 2.9 average of fixed-rate debt sold this year by the government. It was the third sale since the inaugural floating-rate auction on Jan. 29. The notes are considered an alternative to bills because they're benchmarked to a 13-week money market rate.
"We are seeing a lot of cash get parked into the front end of the markets," said Kenneth Silliman, head of U.S. short-term rates trading at Toronto-Dominion Bank's TD Securities unit in New York. "Now, with so much uncertainty about the Fed, you are seeing a lot of liquidity staying very, very short-term."
Libor's Importance
While regulators have been looking into the potential manipulation of Libor, the rate is still important to the market given the amount of debt and contracts tied to it, according to Stanley Sun, a New York-based strategist at Nomura Holdings Inc., one of the Fed's 22 primary dealers that bid at auctions. Libor has fallen by more than half from 0.58 percentage point in January 2012.
"Yes, people understand that Libor is not perfect," Sun said. "But it is a rate that the market still looks at."
Another short-term debt cost, the rate at which dealers borrow and lend securities in exchange for cash through repurchase agreements, has also declined this year. The average rate for borrowing and lending Treasuries for one day in the repo market has averaged 0.053 percent in 2014, down from 0.102 percent last year, according to an index provided on a one-day lag by the Depository Trust & Clearing Corp. Securities dealers use repos to finance holdings and increase leverage.
Money-market rates have dropped even as yields on two-year Treasuries have climbed on Yellen's comments. The two-year note yield rose to 0.44 percent today from 0.32 percent at the end of February. Last month, it reached 0.47 percent.
Record amounts of cash is also leading to an increase in money invested at the Fed overnight through its ongoing tests of a new fixed-rate reverse repo facility. About $242 billion was posted to the facility on March 31, the largest amount yet.
The repo facility currently offers a rate of 0.05 percent and is open to the Fed's tri-party reverse repo counterparties, which includes money-market mutual funds, government-sponsored entities, banks and the Fed's primary dealers. Money market funds, especially, have ramped up usage of the Fed facility at quarter-end, a time when dealers tend to step back from repo transactions as they shore up their balance sheets.
In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.
"The market remains flush with liquidity," said Lena Komileva, an economist at G Plus Economics Ltd. in London. "All is contributing to the collapse" in rates.
With assistance from Christopher Condon in Boston and John Glover in London.
Bloomberg News
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