Borrowing activity in the federal funds market is signaling that stress in the US banking system hasn’t fully gone away.
(Bloomberg) — Borrowing activity in the federal funds market is signaling that stress in the US banking system hasn’t fully gone away.
Although a decline in total volume suggests the overall need for excess cash has lessened, the spread between what borrowers at the highest percentile of the daily fed funds distribution have to pay and those below is at its widest since September 2019. That’s a sign that some smaller institutions are still having to pay more to borrow cash, according to Bank of America strategists Mark Cabana and Katie Craig.
The federal funds market allows government sponsored enterprises such as the Federal Home Loan Banks to lend to foreign and domestic banks in need of dollars. As the Federal Reserve has raised interest rates and shrunk its balance sheet, depositors have shifted money out of banks and into higher-yielding alternatives like money-market funds, prompting lenders to increasingly turn to the fed funds market for overnight cash. The shift was exacerbated by the collapse of four regional US banks earlier this year.
While Fed Chair Jerome Powell said this week that the banking system has settled down, there are renewed concerns over bank liquidity in the wake of Banc of California’s purchase of larger rival PacWest Bancorp.
“We believe it is likely the smaller domestic banks with more limited cash buffers that are driving this upward pressure,” the Bank of America strategists wrote in a note to clients. “Smaller banks have reported to us in the past that they value the fed funds market as a stable source to cover any unexpected short-term liquidity needs when their existing funding falls short.”
The distribution of daily fed funds transactions published by the Federal Reserve Bank of New York shows that interest rates on overnight loans for the 99th percentile has climbed to 5.65%, which accounts for the latest hike. But the gap between the 99th and 75th percentiles has widened to 33 basis points, from near zero in March 2022 when the central bank began its hiking campaign and later quantitative tightening.
The strategists noted that bank call reports show domestic institutions shifting to net borrowers of fed funds from net lenders at the beginning of quantitative tightening. That suggests that liquidity pressure is likely to continue as the balance-sheet unwind continues for the foreseeable future, Cabana and Craig wrote.
The benchmark rate rose to 5.33% on July 26, according to data published Friday, which reflects the central bank’s latest action.
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