Why Treasury Bill Yields are Lower Than the Fed Funds Rate
Why is the three-month Treasury bill's yield lower than the fed funds rate?
-- Saumil Parikh
A good question, and one that's particularly interesting at the moment. The Y2K date change has greatly boosted the supply of fed funds, and that has messed around with the traditional relationship between fed funds and other short-term interest rates.Let's start with some definitions. The fed funds rate, short for the federal funds rate, is the interest rate at which banks lend excess reserves to one another overnight. It is set by the market, but as you probably know, the Fed sets a target for the fed funds rate, and takes measures keep the rate on target. Specifically, the Fed buys government securities from dealers on either a permanent or temporary basis. When the Fed buys securities from a dealer, the dealer's bank sees its reserves increase by the amount of the sale. (See our glossary definition of open market operations for a more detailed explanation of the process.) Currently, the fed funds target is 5.5%. Treasury bills are the shortest-maturity debt obligations issued by the U.S. government. The government issues three- and six-month bills (the actual terms are 91 days and 182 days) every week, and a one-year (364-day) bill once a month. The three-month bill is the benchmark. Bills are discount instruments, meaning that unlike longer-maturity notes and bonds, they don't make interest payments until they mature. Instead, they are priced at a discount to face value. For example, a bill that pays $1,000 at maturity may sell for $986.60, as the most recently issued three-month bill did earlier this week. (The Bureau of the Public Debt Web site has historical information on Treasury auctions.) Bills differ from notes and bonds in another important aspect. While notes and bonds are quoted in price or yield terms, bills are quoted in discount-rate terms, a convention that dates from the days when calculations were done by hand. Basically, a bill's discount rate (not to be confused with the discount rate set by the Fed) assumes a 360-day calendar year. But of course it's possible to calculate yields -- which assume a 365-day year -- for bills, and it's the yield that should be used to compare a bill to any other money-market instrument.
Repo RateTo explain why Treasury bills usually trade at yields lower than the fed funds rate, I'm going to introduce one more interest rate to the discussion: the repo rate. A market interest rate, the repo rate is the rate at which professional traders and investors borrow from dealers the funds they invest in Treasury or other debt securities. Repo loans are collateralized by the securities they are used to buy. For example, if investor A borrows from dealer B in order to buy a Treasury bill and then fails to repay the loan the next day, dealer B can liquidate the Treasury bill. There are different repo rates for different types of collateral. The higher the quality of the collateral, and the more liquid the collateral, the lower the repo rate. Because Treasury securities are of the highest quality and highly liquid, they have the lowest repo rates. I introduce the concept because the relationship between the fed funds rate and Treasury bill yields is easier to understand when you also understand the Treasury repo rate. Treasury repo rates generally hover 5 to 10 basis points below the fed funds rate, for the simple reason that a repo loan is collateralized, while a fed funds loan is unsecured. But why should Treasury bill yields be any lower than Treasury repo rates? A Treasury bill is an obligation of the U.S. government, while a Treasury repo loan is collateralized by an obligation of the U.S. government. Clearly they ought to be the same. But Treasury bill yields are lower -- usually by a factor in the neighborhood of 20 basis points -- because Treasury bills are the quintessential liquid asset, and there are many buyers of bills who will buy them at any price, says Lou Crandall, chief economist at Wrightson Associates. "There's inertia on the demand side," he said. "There are habitual buyers of bills" -- some endowments, for example -- "who have never gotten out of the habit, and so bills are absurdly expensive."
Treasury Isn't Price-SensitiveExacerbating the situation, the Treasury Department, unlike private issuers of debt, issues bills on a rigid schedule, and not according to the level of interest rates. In short, it is as price-insensitive as some bill investors are. Basic market theory assumes, Crandall says, "that supply responds to interest rates just as demand does. But the Treasury has no truck with free-market notions. It is the largest single institutional rigidity in the financial system, and nowhere is that more apparent than in the bill sector." In the last week, both the fed funds rate and the repo rate have on several occasions dived below the three-month Treasury bill yield because the Fed has been supplying the financial system with excess liquidity for the Y2K weekend, so that banks have more than enough cash on hand to dispense a big wad of it to any depositor who wants one. But fed funds and repo haven't remained below bill yields for long, since that's easy money for traders and investors, who can seize the opportunity to finance a bill purchase at a lower interest rate than the bill pays.
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