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Remember when bank reserves were getting burnt up by the Fed’s quantitative tightening? That trend has changed markedly in 2023, and reserves have been mostly flat this year.
The persistence of banks’ reserve levels were first presented to us as a sign that the Federal Reserve has plenty of time before it needs to stop shrinking its balance sheet.
But now that we think of it . . . isn’t it kind of strange for banks to hang on to reserves while the Federal Reserve is steadily reducing the size of its bond portfolio?
QT is supposed to be a mechanical process. When the Fed bought bonds it created reserves, so shouldn’t it destroy reserves when it reduces its bond holdings? That hasn’t happened. Instead the liquidity is coming out of the Fed’s reverse repo facility, or RRP, where money-market funds stash money overnight.
The problem is that it’s expensive for banks to hoard cash today, as Bank of America rates strategist Mark Cabana argues. “Banks are bidding up for liquidity,” he told reporters in a bond-market outlook call on Wednesday.
To draw depositors away from money-market funds, banks are offering higher-yielding cash products — Cabana points to 3- and 6-month certificates of deposit yielding 5.6 per cent — to hold on to reserves that can only earn 5.4 per cent from the Fed. In other words, it’s unprofitable for the banks to hang on to these reserves.
So what gives? Why would a bank hoard liquidity if (at least in theory) they’re losing money on it?
He attributes this in part to the more-than-half-trillion-dollar elephant in the room: unrealised losses on bond portfolios. Bank of America itself has among the steepest losses on that front, with $131bn of paper losses on its held-to-maturity securities in the third quarter.
Banks are also being encouraged to rely less on their lender of next-to-last resort, the Federal Home Loan Banks. Between the regulator nudges away from this fairly popular funding source and the failures of SVB and First Republic earlier this year, banks of all sizes have gotten cautious about managing cash, Cabana writes in a Wednesday note:
Commercial banks live with the recent memory of regional bank failures earlier in the year. Banks know the best way to guard against a similar fate is to hold a large cash buffer. The cash buffers have likely also increased with recent regulatory guidance that Federal Home Loan Bank advances should not be relied upon during times of market stress, which reduces bank traditional funding sources. Recent bank stress & fewer readily available funding sources lead to higher cash buffers.
While the Fed’s Bank Term Funding Program helps ensure that banks won’t have to sell held-to-maturity securities at discounts (and mark down their entire bond portfolios) in a funding crunch, Cabana said there’s stigma to using the facility. Much like the discount window, the Fed’s BTFP is seen as an emergency tool for banks that are under stress and at risk of failure, so it’s likely seen as more prudent to keep a liquidity buffer.
Using the BTFP is “a sign of weakness, and if you want to be perceived as a bank that is a standalone entity without official-sector support, there is no way you’re going anywhere near that thing,” Cabana told reporters on the Wednesday call. “You’re willing to . . . sacrifice a little bit of earnings today, and bid up to hold cash.”
It’s easy to debate the exact breakdown of responsibility for banks’ cash hoarding. But another group of investors are clearly contributing to the declining use of the Fed’s RRP facility.
Money-market funds have been extending the weighted average maturity of their investments in recent weeks, Cabana said, probably because of the view that the Fed is finished raising interest rates.
Money-market fund investments’ weighted average maturity (or WAM) rose “sharply after October’s employment report and CPI print,” said Cabana. Money-market funds “really trust the Fed is done hiking . . . [and] want to extend out of RRP,” he added.
And if banks really do feel a pressing need to hoard liquidity, that could mean that the other part of the Fed’s policy tightening — shrinking its balance sheet — will need to end sooner than economists expect.
Cabana says to watch the overnight RRP facility’s volumes: when they hit zero, that could be a sign the Fed will soon need to stop QT.
