About Turn
About Turn
First, do no harm (to banks) - financial stability trumps inflation
The Fed tightened by 25bps. I’ll wager that’s it - though markets still price another rate rise in May. In the press conference Jerome Powell reiterated the ‘disinflation story is intact’. The banking background and the ‘disinflation story’ suggest rate cuts are coming. I’m not convinced about that disinflation story, but the main focus currently is financial stability. US banks face two distinct issues which can be addressed by cuts. An acute problem with liquidity for some banks (in a system that remains awash with ‘excess liquidity’). And a second chronic problem of negative net interest income (NII) which afflicts the entire industry. Both are caused by the inversion of the curve, and both could be solved by a steepening of the curve by lowering rates. Oh, and there is an overlap with the most highly valued industries in the US and the banks with the problems.
And let’s be honest. The Fed helped cause this problem, so the Fed should respond. The ‘Dash for Cash’ in 2020 created the monetary overhang that led to inflation. Inflation forced the Fed to raise interest rates sharply. Those rates would only ‘stick’ in wholesale markets if the Fed mopped up excess liquidity in the ONRRP, a direct challenge to deposit rates. The liquidity and fiscal boost of 2020/21 delivered record increases in deposits, many of which were deployed in securities investments. Sure, bank management could have done better. But the macro difficulties were set by macro authorities. Those macro settings now need to be reset.
Janet Yellen has assured us regulators and the Fed will ‘ensure that depositors’ savings remain safe. Well, they may be safe, but for depositors to stay in banks the rates need to be competitive. There was ample liquidity for the overall system, but liquidity had migrated to money funds and became ‘sticky’ because the rates are so good, by design. Logic suggests the Fed moves rates down towards the deposit rates, rather than up and further away.
With an inverted yield curve, any securities held by banks (both Available-for-Sale and Hold-to-Maturity) will be subject to negative Net Interest Income, which feeds directly through to the bottom line. Banks have tried to compensate for this by keeping interest on deposits low. But surely that game is up (see above). Banks can also increase rates payable on loans. Both routes are a monetary tightening.
How worried should we be? Not universally worried. Here’s a measure. Published accounts tell us that one of the very largest US banks hold-to-maturity (HTM) portfolio shows an unrealised loss of ~ 9%, while the amortized value of this portfolio is close to par. The portfolio seems to have an average duration of about 4 years. So, this bank has about 4 years in which to amortize a never-to-be-realised loss of 9% on its holdings, about 2.2% per year. That’s a comfortable ask. Given its cash position, no-one need worry about the capital position at this bank. But things are not so good for banks without large cash buffers, or with large securities portfolios or reliance on deposits. There are a few of them, some quite large. The easiest way to alleviate this tangle is to reduce rates and steepen the yield curve.
What about the new measures? The Fed’s new Bank Term Funding Program was designed to alleviate liquidity stress, but it may, unwittingly, act to reveal how deep the problems are. We know that the BTFP will value ‘eligible assets’ at par in return for a one-year loan fixed at a rate of the one-year overnight index swap (OIS) rate plus 10 basis points. At pixel time, the current 1-year OIS is 4.67%, so the BTFP loan currently rate is 4.77%. What bank would pay 4.77% for a one-year loan to repo HTM assets? That’s higher than money-market rates. Only a bank that needed immediately to raise cash for fleeing depositors without selling its HTM assets or a bank that was sure interest rates would rise further. Last week the total call on the BTFP was $12bln. An increase in usage would signal that banks are suffering catastrophic deposit withdrawal. In effect, the BTFP now acts as a ‘fear index’ for the banking industry. This may explain why big banks are prepared to make deposits into regional banks thereby avoiding the need to call on the BTFP.