Asian stock market sell off and half a trillion of repo transactions made by the FED!

I would like to point out that John and I always discuss a few pleasant topics as well as plot the demise of the global economy.   On that note:  Happy New Year everyone (Buon Anno a tutti).

I pointed out to John that Stockman’s analysis did not include any consideration of the amplification caused by derivatives on the destruction to the world/U.S. economy that is going to be felt from the price collapse of oil and basic industrial commodities.   In fact, I would argue, though it’s next to impossible to prove, that the Fed spends a significant amount of time working to prevent any evidence of the brewing derivatives nightmare from reaching overt public view,  in conjunction with the ECB, BoE and U.S. Treasury (the exchange stabilization fund).

An interesting event first brought at least to my attention by Zerohedge occurred on December 31.  The Fed funds (FF) rate plunged significantly below the lower bound of the Fed’s .25-.50% FF rate to the rate set that day at .12% (source:  Zerohedge, with my edits in black) 

The question is, why did this happen?  To begin with, although it went largely unnoticed, the Fed also jacked up the interest it pays on bank excess reserves (IOER) from .25% to .50% at the same time it nudged up the FF rate.   Let’s first review what Fed funds are and how they work mechanically.

The Fed funds is the mechanism by which banks who have cash in excess of what they need to meet reserve requirements lend these “excess” reserves to banks who might need a temporary loan in order meet reserve requirements.  It is thus a system by which banks with extra liquidity make short term loans to banks who need liquidity.  The Fed funds rate is the rate at which excess funds are loaned out. The FF rate is set in a competitive bidding process each day based on the supply of funds made available to lend and the demand to borrow these funds.

In theory the Fed is supposed to be able to “control” the FF rate by regulating the amount of ready-liquidity in the banking system.  The Fed “adjusts” systemic liquidity using the reverse repo and repo “tools” (it can also adjust the minimum reserve ratio but this is rare). If the FF rate is headed above its target range, the Fed repos cash liquidity into the banking system.  Conversely, it uses the reverse repo if the FF rate is headed below the lower bound of its target range in order to remove systemic liquidity.