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June 12, 2023 | As the Treasury begins its refunding this week to raise the largest pile of cash since COVID, ponder how US banks are going to manage to compete with T–bills yielding north of 5.5%. Remember, for every $1 in debt redeemed on the books of the Fed, a bank deposit disappears. If an investor sells a money market fund and buys a T-bill, a bank deposit disappears. This is the newest take on "crowding out" incidentally.
The chart below shows the Fed's total securities holdings and RRPs. Notice that the holdings of MBS are barely running off and that RRPs have climbed above $2.1 trillion as Treasury T-bill issuance came to a halt.
We do indeed hope that most of the Treasury refunding will come from migration of investors out of reverse repurchase agreements (RRPs), but one way or another the US banking industry needs to shed a trillion or so in deposits over the next year. The chart below shows the Treasury general account at the Fed and total deposits for all US banks reported weekly to the Federal Reserve Board.
Back in May, Treasury expected to borrow $726 billion in privately-held net marketable debt during the second quarter of 2023, assuming an end-of-June cash balance of $550 billion. The borrowing estimate was $449 billion higher than announced in January 2023, primarily due to the lower beginning-of-quarter cash balance ($322 billion), and projections of lower receipts and higher outlays ($117 billion). The delay in the debt ceiling has now made the Treasury's cash need even larger.
As banks head into a new funding crisis in Q2, we watch with amusement the growing number of analysts confess to having no clue as to the direction of the markets or interest rates. This lengthening list is only exceeded by the outright capitulation by the bears, though this did not dissuade us from taking a gain on Nvidia (NVDA) around $390 last week. As memories of crypto fade into a haze of private securities litigation, the optimists in the equity crowd proclaim the Age of AI.
The managers of confidence at the Fed and Treasury are trying mightily to get the narrative back on track after the disaster of Q1, when the FOMC’s clumsy handling of monetary affairs tipped over three good sized regional banks. The Fed’s Bank Term Funding Program put a tourniquet on the severed fingers, metaphorically speaking, but the negative cash flow continues to silently eat away at bank book value even as funding costs rise.
Let’s say you’re a bank with a pile of Ginnie Mae 2s and 2.5s sitting in your portfolio. You can repo these mortgage backed securities (MBS) with the Fed at par but at the prevailing rate for repo set by the Fed, dollar swaps + 10bp or over 6%. Yikes. You’re receiving 2% or 2.5% from the Ginnie Mae MBS, but paying out 6% or more for the financing from the Fed? Private repo at fair value is even worse.
The Fed has not taken our suggestion to simply charge the bank the coupon on the MBS. Why is the Fed so miserly? Because it is already losing $1 billion per day, according to Bill Nelson at Bank Policy Institute. As the Treasury refunding proceeds, hopefully a large chunk of Reverse Repurchase Agreements at the Fed will run off, reducing the Fed’s losses. But the fact is those MBS sitting on the books of the Fed now have average maturities measured in double-digit years.
Like banks, the Fed earns ~ 3% on its portfolio of MBS, funded with cash from money market funds that it pays more than 5% on RRPs. While much of the great economics punditry may be clueless as to the next move by the Fed, we can see more policy obfuscation and market volatility ahead. The mechanical process of allowing the Fed's portfolio to shrink will place enormous pressure on banks.
Ignoring market concerns, Federal Reserve officials are signaling they plan to keep interest rates steady in June while retaining the option to hike further later in the year. Just as the spread between Fed funds and the rate paid on RRPs is widening, so too late vintage mortgage paper with 5% and 6% coupons is trading wide of the troublesome low coupon MBS. We suspect the divergence is due to a certainty that interest rates will fall in 2024.
“We are now over 150 bps away from a meaningful refi event (sub 5.50% primary rate),” notes Scott Butchta at Brean Capital. Yet it is interesting to note that the widening spreads on higher coupon MBS and related mortgage servicing assets reveals a fear that these assets could evaporate in an interest rate rally. Depending on how things go for the banks over the next little while, that Fed interest rate cut could come sooner or later.
The big question facing investors, at least those not fixated by the shiny sparkle of AI, is when to go long duration to take advantage of a period of interest rate ease. That eventuality may be a long way off, however, especially if the consumer economy ignores higher interest rates. Meanwhile, look for the level of bank deposits to continue to fall as the Treasury raises nearly $1 trillion in the next couple of weeks.
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