Overnight Rate

The Overnight Rate (also known as the Overnight Lending Rate) is the interest rate at which large banks lend to one another on an overnight basis. Think of it as the financial system's plumbing, ensuring that money flows smoothly between institutions. At the end of each business day, some banks might find themselves with a surplus of cash, while others might be a little short of their required reserves. The overnight market allows the 'cash-rich' banks to lend to the 'cash-poor' ones for a single night, charging this specific interest rate. This rate is incredibly important because it serves as the foundation for most other short-term interest rates. Central banks, like the Federal Reserve (Fed) in the U.S. and the European Central Bank (ECB) in Europe, use the overnight rate as their primary tool to implement monetary policy. By setting a target for this rate, they can influence the cost of money throughout the entire economy, effectively stepping on the gas or the brakes of economic activity.

The mechanism is surprisingly straightforward. Banks are legally required to hold a certain amount of cash in reserve, known as the reserve requirement, which they cannot lend out. If a bank’s daily transactions leave it below this threshold, it needs to borrow money—fast. The easiest way is to borrow from another bank with excess reserves. This interbank loan lasts just one night and is settled the next morning, hence the name “overnight.” While the concept is universal, the specific names and mechanisms differ slightly:

• In the United States, the rate is called the federal funds rate. The Fed’s Federal Open Market Committee (FOMC) sets a target range for this rate. The actual daily rate determined by market supply and demand is called the effective federal funds rate.
• In the Eurozone, the ECB has a suite of policy rates. The most important one that guides the overnight market is the main refinancing rate. The actual rate for unsecured overnight borrowing between banks is now benchmarked against the €STR (Euro short-term rate).

In both cases, the central bank doesn't directly force banks to use a specific rate. Instead, it uses tools like open market operations to add or remove money from the banking system, nudging the market rate towards its target.

At first glance, a one-day loan between banks seems far removed from picking great stocks for the long term. But for a value investor, understanding the overnight rate is like knowing the weather forecast before a long journey. It affects everything.

The overnight rate is the central bank's primary lever for managing the economy.

• Low Rates: When the rate is low, borrowing is cheap. This encourages businesses to invest and consumers to spend, stimulating economic growth. It's the “foot on the gas.”
• High Rates: When the rate is high, borrowing is expensive. This discourages spending and helps to cool down an overheating economy and fight inflation. It's the “foot on the brake.”

As an investor, knowing whether the central bank is stimulating or slowing the economy provides crucial context for your investment decisions.

Changes in the overnight rate create a ripple effect. They quickly influence other rates, including the prime rate—the interest rate banks charge their most creditworthy corporate customers. When the overnight rate rises, so do the borrowing costs for companies. A business with a lot of debt on its balance sheet is particularly vulnerable. Higher interest payments can eat directly into profits, reducing the cash available to reinvest in the business or return to shareholders. A savvy investor always scrutinizes a company's debt load in the context of the current and expected interest rate environment.

This is the most direct and powerful link for a value investor. The “correct” price of any asset, including a stock, is the present value of all its future cash flows. To calculate that present value, you have to “discount” those future earnings using a discount rate. This process is the core of a discounted cash flow (DCF) valuation. The discount rate is heavily influenced by the prevailing “risk-free” interest rate, which is anchored by the overnight rate.

• When interest rates are high, the discount rate used to value future cash flows is also high. This makes those future dollars worth less in today's terms, resulting in a lower intrinsic value for the stock.
• When interest rates are low, the discount rate is low, making future cash flows more valuable today and supporting higher stock prices.

The bottom line: All else being equal, rising interest rates put downward pressure on stock valuations.

While their goal is the same—price stability and economic health—the Fed and ECB operate slightly differently.

• The Fed: The FOMC meets eight times a year to announce its target for the federal funds rate. It's a single target (now a range, e.g., 5.25% - 5.50%) that signals its policy stance to the world.
• The ECB: The ECB uses a “corridor” system with three key rates to manage liquidity more tightly.
  • The Main Refinancing Rate: The rate at which banks can borrow from the ECB for one week. This is their headline policy rate.
  • The Marginal Lending Facility Rate: A ceiling rate for overnight credit from the ECB. Banks can always borrow at this rate if they can't find a lender in the market.
  • The Deposit Facility Rate: A floor rate. It's the interest banks receive for depositing money with the ECB overnight. No bank would lend to another bank for less than what it can safely earn from the ECB.