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(Bloomberg) — Trading in a key overnight funding market surged to the highest in at least seven years, an indication Federal Reserve tightening is putting increasing pressure on liquidity in the banking system.
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Daily borrowing in federal funds rose to $120 billion on Jan. 27, according to New York Fed data published Monday, up from $113 billion in the previous session. That marked the highest level since at least 2016, when the central bank overhauled publication of the data.
Until recently, cash was abundant, thanks to the massive monetary stimulus and fiscal measures unleashed during the pandemic. Now, as the combination of Fed rate hikes and quantitative tightening has led depositors to shift into to money-market funds and other higher-yielding alternatives, banks are starting 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 from a historical perspective,” said Gennadiy Goldberg, a senior US rates strategist at TD Securities in New York. “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.”
The rate on overnight unsecured loans in the federal funds market is the one the Fed targets in its monetary policy decisions. It now stands at 4.33% — up from nearly zero a year ago — and investors expect the central bank to opt for another quarter-point increase Wednesday, at the conclusion of a two-day policy meeting in Washington.
A recent Fed survey hinted at strategies banks may be using to recoup lost cash as funding pressures increase. Financial institutions reported that they would borrow in unsecured funding markets, raise brokered deposits or issue certificates of deposit if reserves were to fall to uncomfortable levels. A large majority of domestic banks also cited borrowing advances from Federal Home Loan Banks as “very likely” or “likely.”
That suggests the jump in fed funds volumes may be driven by Federal Home Loan Banks — the primary lenders in the market — allocating more of their excess cash there instead of alternatives, like the market for repurchase agreements.
On the borrower side, meanwhile, domestic banks have increasingly become bigger participants in fed funds: Their share of borrowings in the market has recently surged to 25%, from levels closer to 5% in 2021, according to Barclays Plc.
“Domestic banks will borrow in the fed funds market only if their intraday liquidity buffers get too thin,” Joseph Abate, a money-market strategist at Barclays, wrote in a Jan. 25 note. “As as result, when bank reserves are abundant, the domestic bank share of fed funds borrowing is very low.”
Still, US dollar funding markets are hardly on the verge of a breakdown, as they were at the end of the central bank’s last quantitative-tightening episode in 2019. At the time, reserves had been depleted to the point that financial institutions didn’t have cash available to lend in overnight markets.
Going forward, though, analysts will be monitoring discount window usage, rates on repurchase agreements and FHLB issuance as potential pinch-points for funding shortfalls.
“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.”
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