Tensions in interbank markets are starting to garner more attention, although there hasn't been much discussion of this development in the context of the upcoming FOMC meeting. Given the threshold for the Fed to "wait-and-see" is still pretty low, this may tilt the risks towards holding rather than hiking at the next meeting.
The catalyst for this looks to be the impending application of a new SEC rule on prime money market funds. As of October 17, prime money market funds are required to apply a floating Net Asset Value (NAV) rather than fixed to $1. This proposed rule change has been floating around for several years.
Why does this matter? Prime money market funds were never guaranteed to not lose money and a fixed NAV does not change the risk of loses. The implosion of Lehman Bros in 2008 led to the Reserve Fund "breaking the buck", with contagion severely stressing credit markets. The SEC rule change is aimed at bringing better transparency to the risks that a prime money market funds may not always be a dollar in, a dollar out.
But a fixed NAV means that from a mark-to-market basis, these funds can be priced as cash for conservative investors. If the NAV floats even marginally below $1, this is could be marked as an accounting loss and could present an unacceptable risk in the event that there is a run on the fund, even if the probability of losing money is no different if the account rule were different.
Not all money market funds must adopt floating NAVs, with those that invest in government and agency debt allowed to keep a fixed NAV.
This is now creating a big shift from prime money market funds, which invest in short-term commercial and bank debt, into those funds which invest only in government and agency debt.
The effect of this on interest rate spreads can be seen in the chart. The LIBOR minus OIS spread measures the difference between bank borrowing rates and the average expected Fed Funds rate by financial markets. Its a key measure of bank funding stress. This has risen to around 40bps, which is around levels seen during the stresses created by the Greek debt challenging the viability of the Euro in 2011 and 2012.
On the flipside, the difference between government T-Bills and OIS rates has become more negative, with yields on short term government debt below expected Fed Funds rate over the next 3 months. This is indicative of the rise in demand for funds investing in government debt.
While most FOMC members have stated that the case for further hikes has strengthened in the last few months, growth has still tended to be weak and inflation low, notwithstanding the tightening of the labour market. This means that there isn't a huge amount of urgency to raise rates in September vs. waiting until the next meeting.
Hiking the Fed Funds rate into a stressed bank funding market could unnecessarily exacerbate problems as they are emerging. While this stress could subside in the not too distant future, this is an important development to keep an eye on given the potential repercussions for many markets of the Fed waiting, even if its ultimately only for a few months.
