Which fire will the Fed fight?

Time for the Fed to steepen the yield curve

We’re used to forest fires in California, but Friday’s hot news from the Golden State poses a three-way challenge. Can the Fed fight the flames of inflation as well as maintain financial stability, whilst still containing painful losses on its QE portfolio? Triage often requires painful choices. Which of the three goals may the Fed have to abandon? The goals of financial stability and return to profit may argue for the Fed to announce victory over inflation and switch to lower rates. That doesn’t help the dollar.

I’ll leave it to others to outline the details of SVB’s demise. But the calamity seems partly the result of problems in maturity transformation that arose from a steeply inverted yield curve.

In an earlier piece I suggested bank stress tests were focussed on metrics that no longer applied. Models used by the Fed (and the European Banking Authority) assumed a steeper yield curve in times of stress. That was the last war. The current financial skirmish sees stress emerging from an inverted yield curve, which even an undergraduate knowledge of banking ‘maturity transformation’ would have suggested.

Photo by Ozzie Stern on Unsplash

Is this a general problem? While there appear to be special features to the SVB bankruptcy, some of its characteristics are recognisable across the industry. Certainly, bank depositors across America feel unloved and footloose. And both Available-for-sale and Hold-to-Maturity portfolios are feeling the heat across the banking industry.

In late February the FDIC reported the average national deposit rate of 0.35%. The Fed’s Overnight Reverse Repurchase Facility offers a guaranteed 4.55% to money-market funds. The nation’s largest money-market fund currently offers customers a 7-day yield equivalent to 4.22% and tells us that 72% of its assets are invested in the Fed’s ONRRP. It is not a hard decision for depositors to shift away from banks even without worries about solvency. Reuters reported a couple of days ago that “assets invested in U.S. money market funds have reached a new all-time high” and recent inflows were higher “than at any time since the depths of the pandemic in 2020.” Total deposits in the US banking system are down 3% since they peaked a year ago.  And if the inverted yield curve is undermining stable deposit funding for banks, the sharp rise in rates is playing havoc with banks’ securities portfolios.

At a Fed policy level, the interplay of ONRRP, Treasury General Account (TGA) and reserves held at the Fed is key to determining stable bank funding at a system level. There may be a issue in how these balance sheet items have evolved.

The growth of money market funds means the orderly decline in ONRRP expected by the Fed is not happening. ONRRP has recently risen in the last month, reflecting inflows into money-market funds. The rise coincides with Jerome Powell’s insistence that interest rates are not going to fall any time soon – meaning money-market funds will remain attractive.  In the last month, total system liquidity adjusted through a fall in TGA ($184bln) which offset the rise in ONRRP ($134bln). But the TGA cannot keep falling at the recent clip, especially if the US Treasury wishes to keep a safe balance of funds until the debt ceiling is resolved.

That leaves the only major Fed liability able to absorb rises in money-market fund holdings are bank system reserves, with implications for repo rates. A study from last year implies a safe level of reserves to avoid spikes in repo rates is around $3. 05 trillion - almost exactly the current level of reserves ($3.00 trillion). If the TGA rises without a decline in holdings of ONRRP, the level of reserves will fall below the safe level and repo may spike.

To be fair, if reserves fall below the ‘safe level’, banks have an incentive to bid for liquidity from money market funds. Competition of this sort may be the reason Large Time Deposits have risen sharply over the last year, in contrast to deposits generally. Plus, the Fed offers the Standing Repurchase Facility to contain repo rates. But that is a short-term palliative measure, not a permanent solution.

And if reserves remain high, the Federal Reserve’s ability to contain losses on its balance sheet is undermined. The plan to contain Fed losses requires interest bearing liabilities to decline by approximately 40% from current levels while coupon paying assets rise.  The easiest way to get interest bearing liabilities lower may be to shrink the ONRRP by reducing the interest rate it pays. That could be achieved by rationing the facility, but that would simply force repo rates lower than the Fed’s Lower Bound and imply the central bank is no longer in control of interest rates.

It may be better publicly to declare victory over inflation and consider cutting rates.

Incidentally, the balance sheet configuration of the largest bank in the US may suggest its senior managers have planned for just such developments for a while.

None of which helps the dollar’s ExorbitantPrivilege.