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Liquidity, Fed Action, and all that Stuff

There’s been a ton of talk in the markets recently about liquidity. We heard about the Federal Reserve and other global central banks inserting reserves in to the system to provide liquidity. So what is all this about?

Let’s start with a definition.

Liquidity is traditionally defined as the ability of one to transact in the market without adversely moving prices. This is normally thought of in terms of exiting a position. For example, you may own a stock and want to sell. In the case of a highly liquid stock you will be able to sell at the current market price with no trouble. Were you dealing in an illiquid stock, however, you could find that your attempt to sell your position pushes prices lower causing you to get lower fill price.

Now based on that basic definition it should be fairly easy to see that liquidity can be very dependent on the size of the transaction in question. Small trades tend to be easily filled with no market impact. A big mutual fund buying 200,000 shares, though, is a different story. In some stocks that kind of volume isn’t much trouble. In others, though, it would be massive and would definitely move the market. That’s why large traders and money managers generally stick to the higher volume instruments.

Now most people don’t necessarily think of liquidity in price terms. They are more concerned about just simply being able to get out of a position quickly when they make the decision to do so. That’s fine.

Liquidity is entirely dependent upon market participants being willing to make transactions. What we have seen over the last few weeks is a situation where that has broken down. Folks looking to sell off mortgage backed securities came to the market and found that no one was willing to buy them. They had to mark down the prices in an effort to try to attract buyers, but still no one wanted to step in. That caused all these hedge funds to blow up.

Last week a similar situation happened in the money market. There was a large demand for overnight reserves. Reserves are the funds that banks must keep on deposit with the central bank to ensure proper coverage of the deposits they have received from their banking customers. If a bank is short of funds it must go in to the market to aquire funds from a bank that has a surplus.

In the U.S. that those reserves are known as Fed Funds and the market for them is the Fed Funds market. The Fed sets the target rate for Fed Funds (currently 5.25%), and while they operate in the market to keep the rate close to their target, the Fed Funds market operates in the same bid/offer fashion as any other. That means if there is a big demand for Fed Funds, they will get bid up (higher rate).

On Thursday there apparently a big demand for Fed Funds, but no one was willing to supply them. Thus, liquidity dried up. The Fed Funds rate was run up to 6%, which was 75 basis points above the Fed’s target rate (1 basis point is 1/100th of a percentage point). The Fed came in, as it normally does, to get the rate back to its target level. That took more than the usual intervention, but it was done.

So what did the Fed do?

Let’s take Friday. The Fed came in three times on Friday to do what are known as repos – repurchase agreements. A repo is an agreement whereby one party purchases a security from another with the understanding that the trade will be reversed at a given point of time in the future. In the case of last week, the Fed was the buyer and they received government backed securities in return for reserves the seller could then apply toward their reserve requirements. By doing that they put more reserves in to the system, creating more supply and bringing the Fed Funds rate down toward the target level.

The repos the Fed did on Friday, about $38 billion worth, were three day repos. That means the transactions were reversed on Monday. That $38 billion in reserves came back out of the system. By that point, though, the liquidity issue had pretty much resolved itself so that further action wasn’t really required (the Fed did a $2bln repo Monday, and none on Tuesday).

I hope that helps you understand all the craziness that happened last week.

One other quick note in that regard. When folks find themselves in a cash crunch they tend to sell off stuff they can easily liquidate. That is partly the explanation for why both gold and stocks were down sharply on Thursday.

If you have any questions on all of this, by all means let me know. I’m surrounded by a bunch of folks who spend their day watching the interest rate and credit markets so I can get answers to just about any inquiry you might have.

By John

Author of The Essentials of Trading

4 replies on “Liquidity, Fed Action, and all that Stuff”

Thank you for a good website, I just descoverd it! My question is regarding why banks would have to borrow at the discount rate instead of the fed funds rate. As I have read banks go to the discount window when the cant borrow at the fed funds rate. But every time fed funds goes over feds target fed act in the repomarket, bringing down fed funds rate. So banks, as I understand it, always can borrow at feds funds rate and the therefore never have to use the discount window. Please help me because there has be something important I miss.

Best regards,
Olle Bastmark
Stockholm, Sweden

Under normal circumstances, banks will use the Fed Funds market to acquire the reserves they need from another bank. The discount window is a kind of last resort that very rarely gets used, not only because the rate is higher, but also because it’s seen as a bit embarassing to the bank forced in to that situation.

In the current market environment, though, the fear factor has a number of banks who would otherwise normally be active in the Fed Funds market as lenders staying away. That has made it difficult for those who need the funds to get them, which is why the Fed and other central banks have been active adding liquidity.

So under which circumstances would you see banks need to go to the discount window? Has someone used it since they cut it by 50bp?

I don’t think the figures have come out yet as to how much activity has gone through the Discount window since the rate cut. I believe I read earlier today that the figures would be released tomorrow, but I’m not positive.

As for why a bank would use the Discount window, there’s only one – they can’t get borrow the reserves they need from another bank. That means either those reserves are not available (no market liquidity) or the potential lending banks do not want the borrowing bank as a counter-party or have reached their lending limits to that bank. The Fed Funds market is unsecured lending/borrowing.