The Fed is still supplying an incredible $200 billion of short term financing to repo markets.  The Fed plans on printing money in order to buy nearly $50 billion in T-Bills a month in a misguided attempt to end the emergency injections of cash.

The Fed already printed so much money that banks have $1.3 trillion of excess reserves (as in excess cash) that is being stashed at the Fed.  The excess reserves were essentially created by the Fed using printed money to buy treasury bonds.  Banks kept feeding the Fed bonds and storing the cash they received for the bonds at the Fed.  The Fed, in turn, then pays banks interest on those reserves at a rate within the target for the fed funds rate.  (If this sounds like a massive government handout to big banks, that’s because it is).

The current rate paid on excess reserves is an attractive 1.80% which is more than T-Bill yields and even about the same yield you earn on a 10 Year Treasury.  Banks have little reason to use this cash to take a potential risk of default in the repo market when they are getting such a sweet deal from the Fed.

When the Fed starts buying huge chunks of T-Bills, T- Bills yields will fall further.  This will make the 1.80% rate earned on reserves look just that much better.  So it’s hard to see how banks would act any differently than they are right now.  Banks will feed the Fed low yielding T-Bills and take the cash and put it with the Fed.  The more the Fed prints and pushes down yields, the more incentive there will be for banks to hoard cash at the Fed.

And the Fed knows it!!  In the minutes of the September 17th – 18th meeting there is a discussion of the then sudden spike of overnight repo rates.  They observed the obvious phenomenon that lenders back away when there is “greater perceived uncertainty” and that “Moreover, some banks maintained reserve levels significantly above those reported in the Senior Financial Officer Survey about their lowest comfortable level of reserves rather than lend in the repo markets.”  So there are ample reserves and printing more money to create more reserves does not solve the problem.

The Fed simply needs to stop paying such an attractive rate on 100% of banks’ excess reserves.  Limiting the amount of excess reserves that can receive interest instantly unleashes liquidity currently locked up at the Fed as banks seek to earn something on the portion of their cash no longer earning 1.80%.

Author Portrait
Bryce Doty is a Senior Vice President with Sit Fixed Income and Senior Portfolio Manager of the taxable bond portfolios for the firm’s custom separately-managed accounts, private investment funds, and mutual funds. Bryce oversees the firm’s team of taxable bond managers, analysts, and traders.