Macroscope | Sudden shift in the normally calm US cash markets doesn’t signal a new credit crunch

When it comes to financial markets, dull is normally a good thing. Being dull is predictable, safe and usually reliable. Cash is about as dull as it gets, or at least it should be. 

That’s exactly why sudden mayhem in a sleepy, obscure corner of the overnight lending markets in the US has recently sparked headlines. A chaotic surge in short-term lending rates signalled that capital markets’ plumbing had clogged up, prompting questions about whether this was a symptom of a more serious problem related to the “normalisation” of the Federal Reserve’s balance sheet.

I grew up in a pretty rural area where rainwater was collected in a tank and then piped to the house. When you turned on the tap and nothing came out, it was either because the tank was empty or the pipes were blocked. This is a simple way of thinking about how the US cash market works.

The Fed is a water tank whose job it is to ensure there is enough liquidity for the smooth operation of markets and to keep the cost of money – that is, the interest rate – as close to the target for the Fed funds rate as possible. The level of water in the tank can vary as the Fed goes about its normal daily operations but, on balance, it has increased markedly over the past decade thanks to successive rounds of quantitative easing to promote economic growth and reach inflation targets.

The pipes that carry the water around the house are the plumbing of the financial system. How fast the water flows and whether it gets to where it is needed depends on the efficient operation of these channels. Just like where I grew up, if debris blocks the pipes, the taps are liable to dry up. The question here is whether a plumbing problem becomes a more systemic market confidence issue.