Not Investment Advice – For Entertainment Only

The Fed is determined to flood the banking system with liquidity. That has direct implications for short-term rates which the market does not appear to fully understand. In this post I will show the theoretical implications of high levels of reserves on short-term rates, and then show how the same policy actions played out in other jurisdictions.

Please take my money!

Commercial banks borrow from the wholesale funding markets to manage their outflows. Every bank has outflows as their depositors withdraw balances to make payments, and every bank has inflows as they receive interest payments from their assets and their depositors receive payments in the course of business. In order manage its outflow obligations, a bank can adjust the profile of its liabilities. For example, it can issue term deposits like 3 month Certificates of Deposits (CDs). This way the bank can better forecast its outflows since they know some portion of their deposits won’t be withdrawn for 3 months. Banks offer a negligible interest rate for their demand deposits, but will pay a premium for a term deposit. LIBOR is a rough estimate of the going rate for term deposits offered by banks to institutional depositors.

In a world where banks have tons and tons of liquidity, they don’t have any trouble managing their outflows. The banking sector becomes flushed with Fed reserve assets and deposit liabilities. In fact, a bank can have too much liquidity. Under Basel III, a big bank’s balance sheet is constrained by a leverage ratio. For example, Alpha Bank may only have room for $1000 worth of assets under its leverage ratio. In that case, it will have to optimize its assets to maximize its return on equity. Fed reserves, which yield 0.1%, don’t help with that. To maximize profits, banks will trim their balance sheet by pushing out unnecessary deposits. (Note: The Fed’s temporary exclusion of reserves from the SLR helps with this at the bank holding company level, but not at bank level). In a world with tons of reserves, banks don’t need or want extra deposits.

In practice, each bank faces different constraints. Some foreign banks are under a more lenient version of Basel III, so their balance sheet costs are lower than domestic banks. When U.S. banks optimize their balance sheet by pushing out unneeded deposits, the foreign banks welcome them—for a price. Foreign banks don’t need the money, but are also not as constrained by the leverage ratio. They will accept the deposits if they can make money on them. They will accept the money if the rate is below the interest on reserves, this way they can just take the money and deposit it at the Fed to earn a risk free spread. This dynamic is usually seen in the overnight unsecured market, but can also occur in the 3M to 12M tenor.

The Prior Big Fed Balance Sheet Expansion

In 2014 when Fed reserves were sky rocketing the 3M LIBOR dropped to below interest on reserves. It stayed there until reserve levels gradually declined.  At the moment, reserves are gradually increasing again and 3M LIBOR is leaking lower again. While the Eurodollar futures market is pricing in a flat 3M LIBOR of 20bps for the foreseeable future, the mechanics of the banking system would suggest that it would reach a level of slightly below IOR, perhaps 5 bps. In addition, should the market expect negative rates, the rate can go even lower.

Japan and the Eurozone Leading the Way

The BOJ and ECB have balance sheet sizes that are significantly larger than the Fed when scaled by GDP. The Fed’s balance sheet is about 33% of GDP, while the ECB’s is 50% and the BOJ’s is 120%. In both those jurisdictions, the money market term structure is flatter than the USD money market curve. Banks have so many deposits that there is no need to pay a premium for term funding.

In recent months the BOJ and ECB recommenced balance sheet expansion. Term money market rates in those jurisdictions dropped to below the opportunity cost for banks (Interest on reserves). In effect, banks were only willing to hold institutional depositor money if they could earn a slight spread.  

I suspect the same thing is coming to the U.S. within a year.