Puzzling Fed Funds rate spike: Sign of hard times to come?

Last week, a couple of days before Americans closed up shot to celebrate America's birthday, something funny happened in the Fed Funds market. According to data from the New York Fed, the borrowing rate on the overnight market on June 30 -- the end of the second quarter for most firms -- hit 7.0 percent, a huge divergence from the recent range of about zero to 0.25 percent. The Fed Funds rate hit the seven percent mark twice during the fall of 2008: first, after Lehman Brothers filed for bankruptcy in September, and then in October when the stock market dropped nearly 20 percent in one week. But there were no such market moving events this time.

The daily Fed Funds rate, which indicates what banks charge each other for overnight loans, is given in a range, and on June 30 the low end of the borrowing range was just 0.01 percent, which makes the exceedingly high top rate all the more puzzling. For the entire month of June, the next-highest reported rate was still only 0.5 percent.

The information is published anonymously, and does not include the size of the transactions nor who the borrower and lender were. Information published regarding the Fed Funds rate on July 1 show the range had returned to within recent normal bounds.

The truly curious thing about the spike in the Fed Funds rate is that the Fed's discount window is open and accepting all manner of securities as collateral, at rates under 0.50 percent. The day before, the Fed lent out $86 billion of a possible $150 billion under the Term Auction Facility at a rate of 0.25 percent, meaning that the borrowing demand was less than the offered supply -- and at rates much cheaper than from going to another bank. All in all, this means that some bank likely had an issue getting collateral to be accepted, despite the wide variety of loans that can be used.

Although it is only one data point toward the end of last week, any further disturbances in the financial markets could be a precursor to another big sell-off, which many bears have been waiting for as the rally off the March lows extends toward four months in progress. With the S&P 500 off about 5 percent from its highs, the Financial Select Sector SPDR ETF (XLF) off 11 percent, and bank earnings poised to be announced in July, this is as good a setup as any for a sell-off to take place.

The chart below shows the Fed Funds rate over the last year; note the spike this week.

James Cullen also edits and writes at CollegeAnalysts.com.

Hat tip: Karl Denninger

Read Full Story