We need a plumber

Today the Fed is expected to lower rates 25 bps. The chairman would probably feel more comfortable keeping rates intact, due to potential inflation pickup as a consequence of tariffs and government spending. But his world is not that simple (neither is ours). US labor market is deteriorating, and several big corporations are already announcing big layoffs. The real employers of the majority of the labor force, the small businesses are suffering and lower rates will help a lot. If that wasn’t enough, commercial and residential real estate need lower rates too. And in the end, everything mentioned above, ends up on banks balance sheets. And that’s what’s starting to look worrisome. In the chart below you can see the bands the Fed offers to banks: the lower one (purple) is the rate at which they pay banks on Repo. The upper one (discount rate, red), the rate at which it lends money to a bank when nobody else is there, seen as a red flag. In normal times, SOFR, the rate at which banks lend money among themselves, generally lives within those two lines, but as you can see, now it is above the upper band, which means the financial basic plumbing is clogged. It’s not functioning properly and banks are taking and lending money to themselves at higher rates than they could obtain with the Fed, because they don’t trust each other. Banks reserves at the Fed have decreased below $3Tn, a mark seen as too tight, signaling as well, there are liquidity issues. When a bank does not have enough liquidity, tends to sell assets, starting with the liquid ones, but remember that banks still have in their books a lot of long treasury bonds bought when rates were zero, that are severely underwater due to their duration, but are not marked to market (because they’re tagged as Held to Maturity), which constitutes a problem, because if they sell them, the losses need to be recognized on the income statement. They probably cannot sell a lot of loans, after the First Brands and Tricolor episodes, so they’re trapped with higher SOFR. Unless the Fed comes to the rescue, with lower rates and perhaps even QE, to unclog the system. The important part today is not the rate, it’s the answer to the question that someone will ask Powell about this during the press conference.

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