The Federal Reserve’s monetary tightening is starting to have an impact on liquidity in the banking system, as indicated by a surge in a key overnight funding market. Daily borrowing in federal funds reached $120 billion on January 27th, the highest it’s been since at least 2016, according to the New York Fed.
In the past, banks had access to ample cash due to the large monetary and fiscal stimulus implemented during the pandemic. However, as the Fed raises interest rates and tightens monetary policy, depositors are shifting to higher-yielding alternatives such as money-market funds. This is leaving banks to turn to other sources to fund themselves.
“The past 12 months have been the fastest pace of rate hikes since the 1980s, so the tightening in financial conditions and increase in funding costs has been quite extreme,” said Gennadiy Goldberg, a senior US rates strategist at TD Securities. “While it hasn’t actually generated a funding crunch, it has sent some banks scrambling as the rapid rise in rates has led to significant deposit outflows.”
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A recent survey conducted by the Fed hinted at the strategies banks are using to recoup lost cash as funding pressures increase. The results showed that financial institutions will borrow from unsecured funding markets, raise brokered deposits, or issue certificates of deposit if reserves drop to uncomfortable levels. A large majority of domestic banks also reported that borrowing from Federal Home Loan Banks was “very likely” or “likely.”
This suggests that the jump in federal funds volumes may be driven by Federal Home Loan Banks allocating more of their excess cash to the market instead of alternative options like repurchase agreements. Domestic banks have also become larger participants in the federal funds market, with their share of borrowing recently increasing to 25% from 5% in 2021.
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US dollar funding markets are not yet on the verge of a breakdown, as they were in 2019 during the last episode of quantitative tightening. Analysts will be monitoring discount window usage, rates on repurchase agreements, and FHLB issuance for signs of funding shortfalls in the future.
“It’s a good sign to see banks compete for funding,” said Rishi Mishra, an analyst at Futures First Canada. “The Fed should be happy with this. Of course, too much of anything is bad.” Despite the increase in federal funds borrowing, the markets are not yet in a state of crisis, but it is important to monitor the situation closely in the coming months.
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