Shyam Vasudevan's Blog

Monday, September 16th, saw a large spike in overnight repo rates, with disruptions in the market still ongoing. What has caused this reaction? First, an explanation of the overnight repo market is necessary. This market gives banks and companies access to short-term dollar funding through the use of repurchase agreements, where borrowers sell collateral in the form of Treasuries and pledge to buy it back at a slightly higher price that determines the interest rate. This rate should be kept in line with the interest on reserves (IOR) that the Federal Reserve pays banks through simple arbitrage. However, the repo rate blew past the IOR rate the previous Monday, requiring Fed intervention in the form of open-market operations that injected additional reserves into the market. The Fed has been continuing this ever since to calm the market and bring the repo rate within the current target range of 1.75-2.00%. The repo rate is determined through the supply and demand for reserves. Due to ...

What can the yield curve tell us about the future path of monetary policy? The two standard theories used to explain the yield curve are the expectations hypothesis and liquidity preference theory. Under the expectations hypothesis, all future interest rates are taken to be equal to their market expectations. The theory implies that investors require no compensation in the form of a liquidity premium for holding long-term bonds, as the yield for a long-term bond is simply the accumulation of rolling over short-term forward rates. In other words, low long-term bond yields today imply market expectations for low short-term bond yields tomorrow. Liquidity preference theory assumes investors demand compensation for the interest-rate risk in long-term bonds. If these investors are mostly short-term, they will demand a premium to hold long-term bonds, which will result in forward rates higher than expected future short rates. This difference is the liquidity premium. On the other hand, ...