Something has been happening to interest rates in the United States this year and it may be one of the myriad of reasons that markets are a bit unsettled. Interest rate policy from the US Federal Reserve has been well flagged and entirely consistent with what has been signposted. But it isn’t US Fed policy that has been the main problem.

The US Federal Reserve announced in October of last year that it is starting the long-awaited reduction in its balance sheet, thus reducing the amount of excess reserves within the financial system. The best way to think about this is that on average the US Federal Reserve is selling bonds back into the banking system that are then bought by banks thus reducing the amount of liquidity/reserve that the banks hold or need to place in money market instruments.

At the same time the supply of these instruments has increased dramatically. As a result of the 2018 shenanigans with the US budget and debt ceiling, the US Treasury has ramped up bill issuance massively in February and March. Newly passed tax reform has also made it more advantageous for US companies to raise funds from issuing Commercial paper in the US market, rather than raid cash from their foreign subsidiaries.

What this has meant is that for the first time since the financial crisis, the Fed funds rate is no longer a good guide to financial conditions in the US. For example, in the table below we look at how the different measures of short-term interest rates have changed this year:

Rate 1 January 2018 27 March 2018 Change
US Federal Funds upper bound 1.50% 1.75% 0.25%
3-month Treasury bills 1.38% 1.77% 0.39%
3-month $ Libor 1.69% 2.29% 0.60%
3-month Top Tier Commercial paper 1.68% 2.21% 0.53%

So although official rates have been rising quite slowly, actual borrowing rates have been rising twice as fast in 2018. It is little wonder that markets are a bit nervous; the last time this occurred was during the financial crisis. The difference this time being that this is not a credit or solvency issue. It’s a supply and demand issue and the effect should begin to fade as the supply demand imbalance reduces.

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