At the current pace, it is likely the Fed could nationalize the entire money market system through its Overnight Reverse Repurchase Program (ONRP). The Fed’s hostile takeover of money markets is not a reason to panic if you have money market accounts.
The implications of the Fed’s actions are not due to a structural problem with money markets but in an attempt to keep money market rates from going negative. The real risk is how the Fed is inadvertently further tightening financial conditions as evident by the recent decline in long-term Treasury bond yields.
By design, Quantitive Easing suppresses or lowers Treasury yields depending on the size and scope of the Fed’s asset purchases. Currently, the Fed is purchasing $120.5 billion a month of two-year Treasury Notes up to 30-year Treasury Bonds, which is putting downward pressure on most of the yield curve.
Quantitative Easing also increases the amount of cash in the banking system as a decline in short-term interest rates leaves savers with few options other than holding cash. Savers frequently look for opportunities to earn more interest on their savings.
With interest rates across the Treasury curve at historically low levels, there is little incentive for savers to tie their savings up. As a result, cash savings increase the longer the Fed engages in Quantitative Easing. The challenge for the commercial banks is they are penalized as their balance sheets increase due to post-Great-Financial-Crisis banking regulations.
As cash started piling up in the commercial banking system, the banks were not incentivized to expand their balance sheets by lending. The cash problem was further exacerbated by repeated rounds of direct-to-consumer fiscal stimulus and enhanced unemployment benefits.
Cash balances in the commercial banking system swelled and the banks were forced to tighten lending standards to avoid further penalties as their balance sheets increased. As interest rates on savings accounts approached zero percent, savers diverted some of their cash to money markets.
Bank in 2016, the Securities and Exchange Commission passed Money Market Rule 2a-7 that forced all money market accounts to be backed by Treasury Bills. As more money flowed into consumer accounts from the government, money market rates nearly went negative.
In an attempt to stabilize money markets, the Fed set its ONRP rate at zero percent to entice the banks into offloading some of their cash onto the Fed’s balance sheet for the night. In exchange for the cash, the Fed loans the banks an overnight Treasury security which they desperately need.
To pay customers interest on their deposits, banks convert customer deposits into bank reserves by purchasing Treasury Bills and short-term Treasury Notes. With a shortage of Treasury Bills, the banks could not get the collateral they need to back this mountain of cash piling up in the commercial banking system.
Due to a shortage of collateral, interest rates had nowhere to go but lower. Once again, money market rates were threatening to go negative. To prevent money market rates from “breaking the buck”, the Fed raised the ONRP rate to 0.05% or five basis points. The decision by the Fed to raise the ONRP rate was a huge relief for the banks and money market funds.
With money market rates below five basis points, money markets funds are incentivized to sell off their Treasury Bills and move all their cash into the Fed’s overnight reverse repurchase program where they are guaranteed five basis points. Fortunately for money market funds, the Fed’s ONRP meets the guidelines set by Money Market Rule 2a-7.
The banks benefit by encouraging customers to move their savings accounts into the Fed-backed money markets accounts that have a slightly higher yield. As customer cash leaves savings accounts for more lucrative money markets, this allows the banks to shrink their balance sheets to avoid further penalties from the post-GFC banking regulations.
The banks are also buying the Treasury Bills the money market funds are shedding, giving the banks the high-quality collateral they desperately need. From the Fed’s perspective, by increasing the ONRP rate, they have stabilized the financial system.
Except there is one unintended consequence of the increasing use of the Fed’s ONRP, which the overuse of ONRP is causing financial conditions to tighten. Inadvertently, by raising the ONRP rate, the Fed raised short-term interest rates which are causing long-term Treasury yields to fall.
By raising the ONRP rate, the Fed is encouraging the overuse of its facilities. Short-term interest rates need to fall to encourage borrowing as there is too much money chasing too few loans. When there is too much money and not enough lending, interest rates need to fall to attract borrowers.
The problem is all the money piling up is in cash, which can only back very short-term loans. There is an insufficient amount of demand for short-term loans to mop up all of this cash. Rather than let rates fall to incentivize borrowers, the Fed has raised the interest rate on cash.
By raising the interest rate on cash, the Fed is deterring otherwise eager borrowers who might take advantage of ultra-low or even negative lending rates. As a result of this miscalculation by the Fed, intermediate and long-term Treasury yields are falling.
Despite the best efforts by speculators to short or sell long-term Treasury bonds, long-term bond prices are slowly rising as financial conditions tighten. With the Fed’s ONRP facility expected to see trillions more flood over the next couple of months as Treasury Bills held by money market funds mature, financial conditions are going to rapidly tighten.
In an attempt to save the financial system from an overabundance of cash, the Fed is once again threatening to crash the economy by inadvertently tightening financial conditions. Long-term Treasury yields are declining, which could lead to a large and unexpected crash in risk assets very soon.