Pod Insights Odd Lots Lots More with Joe Abate on the Fed's New Target and the Rising Price of Money About this episode We're used to talking about the Federal Reserve changing "benchmark interest rates." But the mechanics of how the central bank actually tightens or loosens policy are a lot more nuanced. For years now, the Fed's been doing this through the federal funds market — where US banks lend and borrow their excess reserves. But that could be changing. Last week, Dallas Fed President Lorie Logan argued that the fed funds target is outdated, and the central bank should be looking at alternatives. So what would those alternatives actually look like, and why do the intricacies of these short-term funding markets actually matter? We speak with Joe Abate, head of macrostrategy, at SMBC Nikko about this and the broader liquidity picture. Read More: Logan Ushers in New Era of Debate on Fed’s Key Policy Tool Only Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox — now delivered every weekday — plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.
Transcript Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.
0:00 Tracy Alloway? There are some market stories where you want every detail. Joe and I have made quite a few podcasts on that basis. But sometimes you've only got 10 minutes and just want to know what's moving markets fast. That's the Barclays Brief podcast. Every week, experts from Barclays Markets and Research get you up to speed on what's happening and what to watch next. Concise, focused, and brief. Search Barclays Brief wherever you get your podcasts.
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1:29 Speaker 03 Bloomberg Audio Studios.
1:32 Tracy Alloway? Podcasts, radio, news. Joe one and Joe two.
1:36 Joe Weisenthal? Which one is which?
1:37 Tracy Alloway? Yeah, I have to remember that. Well, you can answer whenever you want.
1:40 Joe Weisenthal? Okay, that sounds good.
1:41 Tracy Alloway? All right.
1:42 Joe Weisenthal? I might just sit back with this one. I might just listen to Joe's answers and then listen to your questions, which would be better than mine.
1:51 Joe Weisenthal? I did a deadlift.
1:52 Tracy Alloway? I am both the most popular trader and most successful trader at Citadel.
1:57 Joe Weisenthal? Fed is going viral.
1:58 Tracy Alloway? Uh, barges.
1:59 Joe Weisenthal? This is an after school special, except.
2:01 Tracy Alloway? I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the US.
2:07 Joe Weisenthal? Black gold.
2:08 Tracy Alloway? These are the important questions. Is it robots taking over the world?
2:11 Joe Weisenthal? No, I think that like in a couple of years, the AI will do a really good job of making the odd lots podcast. One day that person will have the mandate of having.
2:21 Tracy Alloway? How do I get more popular and successful?
2:23 Joe Weisenthal? We do have. The perfect guest. Welcome to lots more where we catch up with friends about what's going on right now.
2:31 Tracy Alloway? Because even when odd lots is over, there's always lots more.
2:35 Joe Weisenthal? And we really do have the perfect guest.
2:40 Tracy Alloway? I think we've been lying to our listeners and our viewers.
2:43 Joe Weisenthal? Go on, this is intriguing.
2:45 Tracy Alloway? We keep saying the Fed is raising or lowering interest rates.
2:49 Joe Weisenthal? Yeah. Oh, I like this. I see. I already see where you're going with this.
2:51 Tracy Alloway? But actually, there's this whole constellation of rates and we never really specify which one.
2:59 Joe Weisenthal? It's less of a lie, more of an omission, et cetera. It is true, especially at the short term level, that there are 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.
3:23 Tracy Alloway? 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?
3:57 Joe Weisenthal? Go on.
3:58 Tracy Alloway? It's Joe Abate.
3:59 Joe Weisenthal? I'm really excited. Let's do it.
4:00 Tracy Alloway? 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 hearing even more from him. Joe, talk to us about how the actual mechanics of raising, changing rates has changed over time.
4:18 Speaker 05 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
5:03 Speaker 05 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.
5:34 Tracy Alloway? It adapts.
5:35 Speaker 05 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. Because there were plenty. Okay. 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.
6:15 Speaker 05 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 IORB. And in an ample reserve-
6:30 Joe Weisenthal? IORB, oh, interest fund-
6:32 Speaker 05 Interest on reserves.
6:33 Joe Weisenthal? Okay.
6:33 Speaker 05 Reserve balances. And that spread has been very, very stable for the last probably four years or so at minus seven basis points because the Fed's been operating in an abundant reserve regime. The abundant reserve regime first came about because of Kiwi, right? So you expanded the Fed's balance sheet, created all these reserves, so banks were overstuffed with liquidity.
7:01 Joe Weisenthal? 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?
7:12 Speaker 05 Who cares about the-
7:14 Joe Weisenthal? 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 arbed 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?
7:39 Speaker 05 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 twofold 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 end game potentially for interest rates.
8:22 Speaker 05 And the second element is kind of more of a mechanical one, which you're referring to as the plumbing.
8:28 Joe Weisenthal? Yeah.
8:28 Speaker 05 Which is, how does the Fed's intentions get translated into bank deposit rates, mortgage rates, et cetera?
8:37 Joe Weisenthal? Right.
8:38 Speaker 05 Right? And one way to think about this is that- All of these term interest rates, 10-year yields, et cetera, are all a reflection of what your expected path of the Fed is, right, defined as Fed funds, plus some premium, to reflect the term risk that you're taking or inflation risk, et cetera. 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.
9:10 Tracy Alloway? I do think in terms of signaling the central bank's actions, it is kind of funny that 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, ample. 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?
9:55 Speaker 05 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, 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, 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.
10:38 Speaker 05 So if you move to a different parameter, let's say a tri-party repo rate, and we can go into details about what exactly that means.
10:46 Tracy Alloway? So one that would be based on an active market?
10:48 Speaker 05 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.
11:00 Speaker 05 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.
11:43 Joe Weisenthal? 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?
11:53 Tracy Alloway? You're very existential today, Joe.
11:54 Joe Weisenthal? 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, its raison d'etre, of running, having a few extra of these tokens in the system?
12:14 Tracy Alloway? Why are we here, Joe? Joe one.
12:17 Joe Weisenthal? Well, no, because like, yeah, Joe. 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.
12:28 Speaker 05 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 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.
13:08 Speaker 05 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...
13:27 Speaker 05 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 oversupplied with bank reserves, their demand for those reserves is excessive and they should be holding, you know, kind of more treasuries than 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.
14:12 Speaker 05 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. 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 flight prone liabilities.
14:55 Speaker 05 So when the Fed began raising interest rates, everything became unglued or became more volatile.
15:03 Tracy Alloway? 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?
15:14 Speaker 05 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.
15:47 Joe Weisenthal? There are some market stories where you want every detail. Tracy and I have made quite a few podcasts on that basis, but sometimes you've only got 10 minutes and need to know what's moving markets and why. That's the Barclays Brief Podcast. Every week, experts from Barclays Markets and research get you up to speed on what matters and what to watch next. About the time it takes to grab a coffee. So, search Barclays Brief wherever you get your podcasts.
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16:42 Tracy Alloway? Okay, I have to ask, why the tri-party rate and not something like SOFR, 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 LIBOR.
16:57 Speaker 05 That's right. I think the main distinction is because the tri-party rate or the tri-party 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, SOFR 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 QSIPS 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.
17:41 Speaker 05 You have a tri-party equilibrium, and then you have a SOFR 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, tri-party market. The result is that you may be... You know, looking at an average or a volume weighted median across all of these markets, that doesn't actually reflect what's going on in the market.
18:14 Joe Weisenthal? So what is the prospect of something fundamental changing in 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, what are the technical challenges with the new implementation?
18:30 Speaker 05 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 SOMA, 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.
19:09 Joe Weisenthal? Okay.
19:09 Speaker 05 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.
19:53 Speaker 05 And then after that, in, I think it was 95, they actually started publishing the target rate in the FOMC minutes.
19:59 Joe Weisenthal? Because it used to just be, you had, you would just... Intuitive, right? It would just, it would arrive there and then they would figure out what the target was.
20:06 Speaker 05 Yeah, they used to use expressions like, expected to put modest pressure on reserve conditions or...
20:13 Joe Weisenthal? 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?
20:23 Speaker 05 Uh, I'm gonna say, no. 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.
20:40 Joe Weisenthal? But I mean, the, what I mean is like, the Fed, does it not need to intervene directly as much the way it did in the old days?
20:46 Speaker 05 Yeah.
20:46 Joe Weisenthal? Because everybody knows that it can achieve it, and so the market will take care of any deviations?
20:51 Speaker 05 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.
21:16 Tracy Alloway? 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. 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?
21:50 Speaker 05 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.
22:02 Speaker 05 And there are a 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 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 five to seven 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.
22:46 Speaker 05 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.
23:27 Speaker 05 Their bargaining power in this negotiation has deteriorated, and they have to pay an extra basis point. And that's what we've seen in recent days.
23:37 Joe Weisenthal? 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?
23:45 Speaker 05 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
24:29 Speaker 05 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 of other It's kind of from somewhere. Other instruments that people use for making payments. Yeah. Right? Deposits. Right. Credit cards and paper currency.
25:13 Speaker 05 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 on-person 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 5/8 of US currency is held offshore.
25:57 Speaker 05 There are 19 billion $100 bills out there. 19 billion $100 bills? Yes.
26:04 Tracy Alloway? I have none of them.
26:05 Speaker 05 No, I have a few.
26:06 Tracy Alloway? Oh, really?
26:07 Speaker 05 Yeah, for the last time I played poker.
26:08 Tracy Alloway? Do you keep them in your wallet?
26:09 Speaker 05 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 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, is 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.
26:54 Speaker 05 Right. Right? So sending money abroad. Again, much easier to do with a payment token. Making purchases theoretically using your credit card in a non-US currency sometimes can get hard, partly because of anti-fraud and other mechanisms. If you used a stablecoin, that might be easier. But the problem, of course, is that a stablecoin 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."
27:32 Tracy Alloway? 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?
27:59 Speaker 05 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
28:41 Speaker 05 that the deterioration in the fiscal outlook was not a unique US phenomenon, 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.
29:08 Tracy Alloway? Although weirdly, the UK one hasn't moved that much.
29:12 Joe Weisenthal? Yeah, I know, they got so much excitement at the beginning of September, and then it's been kind of chill.
29:17 Tracy Alloway? Yeah, well, we'll see what happens.
29:23 Tracy Alloway? Lots More is produced by Carmen Rodriguez and Dashil Bennett with help from Moses Ondom and Kale Brooks.
29:29 Joe Weisenthal? Our sound engineer is Blake Maples. Sage Baumann is the head of Bloomberg Podcasts.
29:34 Tracy Alloway? Please rate, review, and subscribe to Odd Lots and Lots More on your favorite podcast platforms.
29:39 Joe Weisenthal? And remember that Bloomberg subscribers can listen to all of our podcasts ad-free by connecting through Apple Podcasts. Thanks for listening.
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