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Foreign banks' cash declines in latest week
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Fed funds rate pinned at higher level of 4.09%
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Fed funds futures hit record open interest last week
By Gertrude Chavez-Dreyfuss and Laura Matthews
NEW YORK, Sept 30 (Reuters) - The effective federal
funds rate - the interest banks charge each other for overnight
loans to meet reserve requirements - rose unexpectedly last week
ahead of quarter end, mainly on the back of shrinking cash
balances at foreign banks, according to market participants.
The latest fed funds rate of 4.09% was one basis point
higher than the 4.08% seen after the Fed cut interest rates at
the September 16-17 meeting. It's still within the Fed's range
of 4.00% to 4.25% though.
So-called foreign banking organizations or FBOs are
major players in the roughly $100 billion fed funds market. The
fed funds rate is central to the financial system as the
official policy reference that the Federal Reserve sets a target
range for each time it meets.
The uptick in the fed funds rate comes shortly after the
Federal Reserve lowered the range by 25 basis points, even as
the market grows cautious over a potential liquidity crunch as
September comes to a close, along with the quarter. The modest
increase was the first outside of a Fed rate move since 2023.
The effective fed funds rate is market driven and in recent
years usually hovered 8 bps above the lower end of the fed's
target range.
Analysts noted that the ongoing buildup in the U.S.
Treasury's cash balance has siphoned off reserves from the
banking system, including those from FBOs. That cash
effectively reduces bank reserves as it grows.
The latest data showed total bank reserves, which include
those from FBOs, have fallen to $3 trillion as of September 24,
from $3.3 trillion a few weeks ago. FBO reserves represent about
38% of total reserves at the Fed, while U.S. banks hold 57% and
credit unions have 5%, according to the New York Fed's Liberty
Street Economics.
FBO cash holdings, a proxy for reserves, fell to $1.176
trillion as of the latest Fed data from September 17, down $28
billion from a week earlier. Since August 20, their cash has
declined by $255 billion.
FBOs are major borrowers in the fed funds market, a source
of liquidity that also provides opportunities for arbitrage.
Foreign banks borrow at a lower rate of 4.09%
from Federal Home Loan Banks (FHLBs) in the fed funds sector and
then park the cash as reserves at the Fed earning an interest of
4.15%. That rate is called the interest on reserve balances
(IORB.
The decline in foreign bank reserves has tightened liquidity
in the fed funds market, while reducing trading volume, analysts
said. After averaging $113 billion per day from late April until
September 12, the fed funds volume fell to an average of just
$94 billion. On Friday, that volume was $95 billion.
"If you look at the distribution of those reserves, they
have come down, particularly from non-U.S. banks," said Joseph
Abate, head of rates at SMBC Nikko Securities.
"They don't have access to FHLB advances and they don't have
an insured deposit base so their funding tends to be less stable
and therefore they like to maintain thicker liquidity cushions."
Domestic banks typically don't engage in this arbitrage
because it increases their balance sheet size and triggers
leverage ratio and liquidity coverage ratio (LCR) costs,
analysts said. Those regulatory costs often eat up or exceed any
spread between fed funds and IORB.
BANK RESERVES AND QUARTER-ENDS
There are obvious explanations for the decline in FBO
holdings, analysts said, with such moves coinciding with the end
of financial reporting periods, but they usually recover after
that. The latest decline, however, began well before the
end-August date and continued into September.
Lou Crandall, chief economist at money market research firm
Wrightson ICAP noted that "while some of this decline reflects a
shift into alternative front-end investments like repos," the
bulk could be attributed to deleveraging in the balance sheets
of foreign banks.
That said, the tick higher in the fed funds rate, while
unexpected, did not surprise some analysts given that overnight
repurchase (repo) rates are also trending firmer ahead of the
end of the quarter.
Repo rates, or the cost of borrowing overnight cash secured
by Treasuries or other debt securities as collateral, tend to
spike at the end of a quarter or year as primary dealers, mostly
large banks, reduce their activity as middlemen in money market
transactions due to higher balance sheet costs.
FED FUNDS AND FUTURES MARKET
The fed funds move has spurred selling of futures tied
to it, analysts said, leading to record open interest at the
CME, suggesting possibly tighter funding conditions in repos at
the end of the quarter.
Futures open interest hit a record last Tuesday,
surpassing three million, CME data showed. It was at 2.9 million
last Friday. There was also a massive block trade of 30,000
October contracts on fed funds futures seen on Wednesday, the
equivalent of $1.25 million per basis point in risk.
In the end, Josh Barone, wealth manager at Savvy Advisors,
said the fed funds blip was all about plumbing, not policy,
echoing other people's view that it likely reflects
balance-sheet constraints at the end of the quarter.
(Reporting by Gertrude Chavez-Dreyfuss and Laura Matthews;
Editing by Alden Bentley and Andrea Ricci)
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