Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

Updated: 3-20-2023: Silicon Valley Bank’s collapse has caused savers to seek out alternatives, but the shift poses risks to the financial system and the wider economy. Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

After the most tumultuous month since the 2008 financial crisis, banks are finding themselves in an impossible position.

Keeping interest rates on deposits near zero is becoming increasingly untenable, with the collapse of Silicon Valley Bank, Signature Bank and Silvergate Capital Corp. putting savers on high alert for better and safer alternatives.

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But raising rates enough to compete with money-market funds is also a nonstarter that would crush profit margins and potentially roil stock prices.

It’s forcing a rethink about the traditional role lenders have had in the US financial system and the economy — and whether there are just too many of them.

The turmoil has underscored that there are other places people and companies can park their spare cash and get a better interest rate.

Over the past three weeks, what had been a slow flight from low-yielding savings accounts has become a turbocharged sprint to higher-earning alternatives. And smaller banks are feeling the pain much more acutely than their giant peers.

Deposits at such lenders slumped $120 billion in the week ended March 15 while those for the 25 largest firms rose almost $67 billion, Federal Reserve data showed.

Outflows at US lenders more broadly continued the following week, with $125.7 billion withdrawn, though smaller banks posted a slight increase.

For more than a decade, banks had been able to pay rock-bottom rates to depositors. When the Fed slashed interest rates in the financial crisis, it opened a low-rates era that allowed banks to borrow cheaply and earn handsome profits from lending.

Now, the ground is shifting. The Fed has been raising its borrowing benchmark at a rapid clip over the past year in a bid to tamp down inflation — but banks have been slow to boost the rates they offer to customers, fearing what it will mean for their margins.

“The bottom line is, deposits were really taken for granted for a very, very long time because of the zero interest rate environment, and now that’s completely changed,” said Joseph Plevelich, senior research analyst at Pekin Hardy Strauss Wealth Management.

Even before the rapid-fire bank collapses, lenders had been confronting strains created by the Fed’s aggressive rate hikes. Lower-yielding investments and loans are dragging down bank profitability even as it becomes more expensive to borrow money to fund further lending.

Money-market funds, on the other hand, have been much more nimble in passing on the Fed’s rate hikes. There is now a record $5.2 trillion piled up in them and some predict that the flow from banks to funds can go even further.

Money funds park cash in short-term instruments, such as Treasury bills or repurchase agreements, and pass on what they earn to investors.

Though the immediate anxiety about more bank failures has eased, investors have continued to pump cash into money funds, pushing some $66 billion into US money funds in the week ending March 29, according to the Investment Company Institute.

Less Lending

The move from bank accounts to money funds and other instruments is likely to put more cash in the pockets of long-suffering savers, but there is concern that a dearth of deposits will leave the US with a smaller number of community and regional banks who have less money to lend — and that in turn could hold back growth and worsen inequality.

Many banks are barely trying to compete with money-market funds to lure customers back. They’re either unwilling or unable to raise deposit rates as they’re still suffering from losses from investments made in lower-yielding assets before the Fed began raising rates.

Some banks that dangled higher rates have collapsed: Signature and SVB offered among the highest deposit rates in the industry.

Even the nation’s smallest banks play a major role in the economy. A 2020 Federal Deposit Insurance Corp. report indicated community banks — institutions with $10 billion or less in assets — held 36% of small business loans, even though they accounted for only 15% of total loans within the sector.

Bank loans are a crucial source of funding for small businesses, which employ about 46% of Americans who work in the private sector and have generated nearly two-thirds of jobs created since 1995, according to the US Small Business Administration.

The prospect of widening wealth inequality — a trend that the Fed was hellbent on reversing as part of its 2020 framework change — looms large for economists including Krishnamurthy Subramanian, an executive director at the International Monetary Fund.

Community and regional banks are crucial lenders to individuals and small businesses far removed from the biggest, wealthiest US cities.

“The people who bank with them, who are not as well-to-do,” will be most affected by the struggles of smaller banks, said Subramanian, a former chief economic adviser to India’s government. “Large banks will not be the ones hit this time.”

Plugging The Gap

For now, the fallout from the deposit exodus has been contained. The Fed, along with the Federal Home Loan Banks, has plugged a big chunk of the funding gap.

And the FDIC’s decision to backstop previously uninsured deposits at SVB and Signature Bank has helped ease some savers’ concerns about the safety of banks.

However, some industry observers say those steps can only buy so much time, and that the flow of funds away from lenders will likely go on.

“Until the regulators or the government say in fact all deposits are insured, the implied insurance doesn’t really count,” said Joseph Mevorah, a senior managing director with Empire Valuation Consultants. “Over the course of the next few months, you’re going to see a steady trickle away from those banks.”

Mevorah started his career liquidating failed or failing thrifts during the savings and loan crisis, financial panic sparked by aggressive interest rate hikes that led to a federal bailout for the industry and an overhaul of banking regulation.

A steady drawdown of deposits isn’t the only challenge facing banks.

Since the Fed’s fight against inflation began, banks have watched the value of their substantial bond holdings erode, as debt bought when rates were lower is worth less as rates climb.

The same can be said of mortgages and other loans banks made when customers who were eager to lock-in low rates opted to borrow.

While accounting quirks have shielded banks from the worst impacts of those unrealized losses, banks are still facing significant friction that will erode profits in the short term and could do more damage down the road.

Margin Squeeze

It was clear even before the most recent crisis that some banks were leaking deposits, pushing them to lean more heavily on alternative funding sources, such as the FHLB system.

Some also responded by boosting the rates they offered on deposits in a bid to lure back savers, but even with that average rates remained well below what money funds and other venues were able to offer.

Jacking up interest rates on savings accounts and certificates of deposits can draw in cash, but it’s also likely to squeeze banks’ net interest margin, or NIM, a key measure of their financial health that compares how much they make from interest-bearing assets like loans against what they pay on interest-bearing liabilities like deposits.

“That earnings number will look way worse,” said S&P Global analyst Nathan Stovall. He said that could lead to consolidation if it pushes bank executives who were already contemplating a sale past the tipping point.

“You might’ve been willing to accept some margin compression. You might’ve been willing to accept a 5% decline in earnings,” said Stovall. “But are you willing to accept 10 or 15? I think that could push people over the edge.”

Updated: 3-30-2023

Why US Banks Are Hemorrhaging Deposits To Money Funds

Americans are changing where they park their cash, with money market funds becoming more popular than ever. The shift away from bank deposits and into these funds gathered pace in the last year as the Federal Reserve increased interest rates to fight inflation.

Many banks were slow to pass on those increases to customers, so the draw of higher money market yields has prompted many savers and companies to seek out alternatives.

The shift was turbocharged more recently by concerns about the safety of small and midsize US banks, sending the total amount in money funds to around $5.2 trillion.

If these banks keep losing deposits to money markets and their bigger banking peers, there’s a risk that they will dial back lending in a way that causes a larger economic slowdown than the central bank is trying to engineer.

1. What Happened To Deposits?

As the Fed started raising interest rates in 2022 and signaled its intention to tighten policy further, the market yields offered by various short-term instruments from Treasury bills to repurchase agreements climbed.

In turn, money funds, which put dollars to work in these kinds of securities, also raised the rates they offered to investors.

Banks passed on some of the rate benefits to depositors, but not all. Because firms were sitting on a mound of deposits from pandemic-era stimulus programs, they could afford to let that money flee for higher-yielding alternatives and instead keep rates low to shore up their margins.

That was fine for a while, but by late 2022 evidence emerged that some banks were starting to scratch around in funding markets to make up for deposit shortfalls.

That exodus accelerated this year as the failure of three banks and solvency concerns about others sent retail and corporate investors piling into money market funds.

2. What Are Money Market Funds?

Money market funds invest in a variety of short-term cash-like instruments. These include Treasury bills — US government securities that mature in a year or less — as well as repo agreements, a type of short-term lending secured by bonds that the borrower owns.

Some money funds also invest in short-term corporate IOUs known as commercial paper. Right now, though, a massive chunk of the total appears to be simply warehoused in the Fed’s overnight reverse repo facility rather than finding its way back into the economy.

3. What Has Made Them So Popular?

Money funds have long been a popular destination for companies and others to stick cash that they don’t need right now but might want to tap on short notice.

They got a big bump in popularity in early 2020 as pandemic-related cash infusions flooded the financial system, and took another significant leg up in the past few months as the rates offered by money funds outstripped those being provided on bank deposits.

4. Why Doesn’t Everyone Just Put Their Cash There?

Many savers stick with their banks out of inertia or complacency, but traditional bank accounts also have some advantages over money market accounts. Banks provide people with ready access to their money as well as associated conveniences like checking accounts and mortgages.

For customers willing to lock up their cash for periods of time, banks also offer certificates of deposit that pay a fixed rate of return, whereas money market yields move up and down.

On top of that, savings accounts are insured by the Federal Deposit Insurance Corp. — officially up to $250,000 per depositor, but in reality perhaps more after the collapse of Silicon Valley Bank prompted the agency to go beyond its normal limits.

Because of these advantages offered by banks, money funds need to offer a yield premium to lure people in.

5. How Risky Are Money Funds?

The cash that into US government money funds is invested either directly in Treasury securities, in instruments linked to similar assets like repo agreements, or in central bank facilities. But like any investment vehicle, there’s risk. Back in September 2008, the collapse of the Reserve Primary Fund — the oldest US money market fund — spurred a run on other funds.

A lot has changed since then, however, with the government undertaking several rounds of money-market rule changes aimed at protecting investors in times of crisis and making the financial system more resilient.

These included requirements for funds to invest in more liquid assets and tighten up their risk management.

The industry is even girding itself for the Securities and Exchange Commission to announce a third set of changes that have been debated since the pandemic.

6. What Happens If Banks Keep Ceding Cash To Money Funds?

If money funds continue to prove more attractive for savers than deposit accounts, banks will either need to lean on more expensive sources for funding, dial back their lending, or a combination of the two.

Small and midsize banks, which have lost the most deposits, have been among thee biggest drivers of loan growth in recent years, so anything that crimps them could have outsize knock-on effects for the economy.

Of course, the Fed is actually trying to engineer a certain amount of that as it uses tighter monetary policy to combat inflation. But a sudden rush of cash out of the banking system — in excess of what’s already been moved — risks increasing the odds that a so-called soft landing might morph into a deep recession.

Money-Market Fund Assets At Record $5.2 Trillion As Rates Beckon

* Balances Have Risen By More Than $300 Billion Through March 29
* Government Money-Funds Saw Assets Rise To $4.33 Trillion

The amount of money parked at money-market funds climbed to a fresh record in the past week as banking concerns continued to rock global markets and attractive rates lure investors.

Money-market funds have been scooping up cash recently, fueled in large part by depositors pulling their money away from US banks. Initially much of that flow was driven by more attractive rates, but concern about the steadiness of some smaller lenders helped turbocharge that this month.

About $66 billion poured into US money-market funds in the week to March 29, according to data from the Investment Company Institute. Total assets were $5.2 trillion versus $5.13 trillion in the week to March 22.

The week before, about $117.41 billion in net new money was placed in the funds. That came as fears about the state of the banking system fueled risk aversion globally and spurred demand for high-quality, liquid assets. Money-market funds got roughly $304 billion of cash in the three weeks to March 29.

The prior record for weekly inflows was $286 billion, reached in March 2020, based on ICI data that goes back to 2007. Back then, a ramp-up in concern over the economic fallout from the coronavirus pandemic sent investors running for havens in money-market funds.

In the week to March 29, government funds, which invest primarily in securities like Treasury bills, repurchase agreements and agency debt saw assets rise to $4.33 trillion, a $71.1 billion increase.

Prime funds, which tend to invest in higher-risk assets such as commercial paper, saw assets fall to $757.3 billion, an $8.1 billion decline.

Cash Stashed In Funds Instead Of Banks Fuels US Slump Risks

* More Than $5 Trillion Has Been Plowed Into Money-Market Funds
* Smaller Banks Are Bearing The Brunt Of The Exodus By Savers

Money-market mutual funds are proving an irresistible place for investors to park their cash right now instead of banks.

The amount squirreled away in them has surged to more than $5 trillion and that risks becoming a problem for the US economy if that grows too much and too quickly.

Encouraged by the higher rates that these funds have been able to offer — and their greater nimbleness in passing on benchmark increases by the Federal Reserve over the past year — savers have been shifting cash into them and out of traditional bank deposits.

That was happening even before the recent banking turmoil, but the trend has been supercharged amid the collapse of Silicon Valley Bank and other lenders.

“Depositors are noticing” the gap between what banks and money funds are offering in terms of interest rates, Barclays Plc money-market strategist Joseph Abate wrote in a note to clients. “We expect flows into money funds to grow by several hundred billion dollars, heating up bank deposit competition.”

An ongoing funding pinch for financial institutions risks having knock-on effects for banks’ willingness to lend, which in turn could weigh on the provision of loans to consumers and businesses.

Of course, a certain amount of that is what the Fed is actually trying to engineer as it uses tighter monetary policy to combat inflation.

But a sudden rush of cash out of the banking system — in excess of what’s already been witnessed — risks increasing the odds that a so-called soft landing might morph into a deep recession.

Assets in money funds have now reached a record $5.2 trillion, according to data from the Investment Company Institute, with more than $300 billion of that being added in the three weeks to March 29.

Money-market funds invest in a variety of cash-like instruments from Treasury bills to repurchase agreements, with a smaller subset also putting funds to work in short-term corporate IOUs.

Right now, though, a massive chunk of the total appears to be simply warehoused in Fed facilities rather than finding its way back into the economy.

Close to $2.3 trillion is stashed in the Fed’s reverse repo facility, which offers an annual rate of 4.80% for overnight cash and is primarily used by money-market funds.

The rate that facility offers is attractive compared to many short-term money-market instruments such as Treasury bills, and that’s helped keep usage consistently above $2 trillion since the middle of last year.

And because it’s being sidelined at the Fed, that’s essentially money that isn’t being put to any use — for now at least.

The rate on the Fed’s RRP, as it is commonly known, also outstrips by far what most banks are offering, with the average one-year certificate of deposit rate somewhere around 1.5% right now, according to data from the Federal Deposit Insurance Corp.

If money funds continue to prove more attractive for savers than deposits, the downward pressure on banks’ reserve levels may remain or even increase. Smaller US banks have seen deposits drop, raising concerns about a reduction in lending to businesses and households if the outflows continue.

Fed figures show that while the biggest 25 banks added some $120 billion in deposits in the week through March 15 — the period when SVB failed — smaller lenders lost $108 billion from their accounts.

Critically, it’s smaller banks that have been the biggest drivers of lending over the past few years. The largest banks have a combined $6.5 trillion of loans outstanding — compared to $4.5 trillion for the rest — but it is the smaller lenders that have grown lending more since 2020, according to Fed data.

Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

Even before this month’s tumult, banks were already tightening lending standards to businesses and witnessing weaker demand for loans, according to the Fed’s January survey of senior loan officers.

That same report also showed that lending to households was either unchanged or tighter.

“This has been a direct byproduct of large-scale Fed rate hikes, and rapid tightening in lending standards has been historically consistent with sizable growth downturns and/or stress in financial markets,” Jason Daw, head of North American rates strategy at RBC Dominion Securities Inc., said in a note to clients.

Tighter financial conditions make the market more attuned to risks that the economy could slip into a recession and raises the odds that the Fed will start cutting rates sooner rather than later. Pricing of swaps linked to central bank meetings suggest more than half a percentage point of cuts are likely by the end of the year.

What’s worrisome is that continued uncertainty and inflows into money-market funds make a normal process more disorderly.

In the meantime, some have argued that the Fed needs to adjust the parameters on its reverse repo facility, either lowering the rate it pays or reducing the amount each counterparty can park at the Fed.

The Bank Policy Institute, an advocate for lenders, is one organization that’s been actively pushing for changes to the rate offered on reverse repo facility, which it says is causing damage.

Yet, even if the Fed did make those kind of tweaks, there’s no guarantee that the cash pushed out of the central bank would wind up in the accounts of the banks that need that cash the most.

Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

Meanwhile, Treasury Secretary Janet Yellen, appearing on Thursday at a conference of business economists, spoke about some of the risks surrounding money funds themselves.

She said that “the financial stability risks posed by money market and open-end funds have not been sufficiently addressed” and noted that noted that mitigating vulnerabilities in nonbank financial intermediation is one of the top priorities of officials.

All this puts the banking system at a crossroads. Banks can aggressively boost the rate paid to depositors even though it will still lag money-market yields. They could tap funding avenues like the Federal Home Loan Bank system or tighten lending standards to reduce funding needs.

They could also realize losses by selling securities to support loan growth, but that would negatively affect their earnings and regulatory capital.

There’s also a risk that these outflows continue, especially as the Fed keeps rates elevated and marches on with the unwinding of its balance sheet.

“There isn’t a systemic banking issue as of this moment,” said Zachary Griffiths, senior fixed-income strategist at CreditSights Inc. “If we’re wrong and banks tighten their belts much more as deposits shift and the overall thinking about the ‘stickiness’ of deposits changes more holistically, then we could be in for a more pronounced economic downturn.”

Updated: 4-3-2023

Cash Exodus Shows Just How Much Quicker Funds Adapt To Fed Hikes

* Funds Historically More Nimble In Passing On Fed Rate Changes
* Total Size Of Us Money-Market Funds Has Topped $5 Trillion

The recent flood of cash from bank deposits to money-market vehicles has sharpened investors’ focus on just how much more nimble those funds are in passing on interest-rate changes by the Federal Reserve.

Over the past two decades, money funds have passed on around 88% of changes in central bank interest rates, compared with just 26% for rates on retail cash deposits — more than three times the amount — according to an blog post from the Federal Reserve Bank of New York.

And that dynamic, combined with lag effects, means that there’s scope for money funds to keep ballooning in size.

Updating a study that was originally conducted in 2019, the New York Fed researchers conclude that money-market vehicles have continued to respond with greater alacrity during the most recent cycle of central bank interest-rate increases.

As a result, they posit that the growth of the US money-market mutual fund industry is set to continue in the wake of the hikes implemented by the Fed during the past year.

“During the current tightening cycle, MMF yields have increased by 4.13 percentage points, in line with our previous estimate of the beta on MMF shares between 2002 and 2020,” a team of researchers, including Gara Afonos, wrote in a post Monday on the New York Fed’s Liberty Street Economics blog. “In contrast, deposit rates have remained flat.”

Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

They noted that between April 2022 and January 2023 — which encompassed much of the Fed tightening — money fund assets increased to $4.62 trilllion from $4.31 trillion in April 2022.

The researchers judged that to be “relatively small” given that the Fed had increased its benchmark target by 4.25 percentage points by the end of January to a range of 4.25%-4.50%

That was “likely due to a lag with which monetary policy affects investor flows in MMFs,” the NY Fed staffers said in the blog.

“The recent monetary policy tightening, in fact, could lead to a further expansion of the MMF industry in the near future.”

The amount of cash parked in money funds has grown further since then following additional rate increases by the Fed — its benchmark range is now 4.75%-5.00% — and the banking turmoil that surrounded the collapse of Silicon Valley Bank and other lenders.

With fears around the prospects for smaller institutions prompting many to pull cash from bank accounts, total money fund assets have now ballooned to $5.2 trillion, according to data from the Investment Company Institute.

That includes more than $300 billion of net new funds in just three weeks.

Of course the speed at which money fund companies respond relative to banks to Fed rate increases is mirrored in reverse during periods of monetary easing.

That is something that traders are pricing in over the horizon, but before then the market suggests there will probably be at least one more hike to come — at the Fed’s next meeting.

Current pricing in swap markets shows a quarter-point hike in May is seen as more likely than not, while pointing to more than half a point of cuts by the end of 2023.

“The gap between the deposit and MMF betas increases the appeal of MMF shares relative to bank deposits when the Federal Reserve tightens its monetary policy and decreases their appeal when the Federal Reserve cuts rates,” the researchers said in the blog. “As a result, the size of the MMF industry tracks the monetary policy cycle, albeit with a lag.”

Updated: 4-5-2023

Investors Seen Pouring $1.5 Trillion More Into The Safest Money Funds, Barclays Says

* More Cash Set To Move Into Government-Only Money-Market Funds
* Search For Safety And Better Rates Are Key To Continuing Trend

The wave of cash plowing into the safest of money-market mutual funds has only just begun with as much as another $1.5 trillion set to enter over the next year, according to Barclays Plc.

Coffers of government-only money funds, which invest just in securities with virtually no credit risk such as Treasury bills and repurchase agreements, have already ballooned since fears of a banking-sector crisis erupted last month.

A continued exodus from banks and rotation out of prime funds, which can buy more risky debt, will only further fuel that trend as investors search for higher yields and greater safety, Barclays says.

“We expect money fund balances to increase sharply in the next year,” Barclays money-market strategist Joseph Abate wrote in a note to clients. “While it seems that the concerns about broader bank solvency are fading, they appear to have caught the attention of this deposit base. Institutional investors have noticed that they were not getting as much compensation for taking on unsecured bank risk by keeping bank deposits above the $250,000 insurance cap.”

The amount of money parked at all money-market funds climbed to a fresh record last month as banking concerns unsettled global markets and attractive rates lured investors.

Their cash pile jumped by roughly $304 billion in three weeks, bringing total assets to $5.2 trillion as of March 29, according to data from the Investment Company Institute. A fresh update from ICI will come out on Thursday.

Besides the exit from banks amid fears of further runs in the wake of the demise of Silicon Valley Bank and two other regional banks, investors have pulled cash from deposit accounts as increases in those rates have trailed yields for money funds, which have better adjusted to the Federal Reserve’s most aggressive hiking cycle since the Volcker era.

New York Fed researchers quantified that rate disparity and its effect on money flows this week in a blog post.

One potential destination favored by government-only funds is the Fed’s reverse repo facility. But whether fresh cash mostly finds its way to so-called RRPs will depend on the supply of attractive alternatives.

Money parked in RRPs last week jumped to its highest so far this year at $2.375 trillion, though has edged lower since.

Projections for money-fund inflows signal “heavy future inflows into the Fed’s RRP,” Abate wrote. “But just how much goes into the Fed’s program depends on the availability of alternatives like bills and private sector repo, as well the willingness of fund managers to extend their portfolio weighted average maturities.” Yet the path for RRP balances is uncertain and swings in usage could create other issues, he said.

“On-and-off swings in the use of the Fed’s RRP during QT caused by exogenous factors – like the supply of alternative assets and the effect of prime fund reform – could echo through overnight interest rates,” Abate said. “In turn, these rates could temporarily swing up and down, ‘self-correcting’ the reserves scarcity created by the RRP.”

Deposit Outflows Shine Light On Fed Program That Pays Money-Market Funds

Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

Reverse repo offers interest on firms’ cash balances, but some analysts say flows add to bank-system stress.

Banks are under pressure from depositors’ embrace of money-market funds, pushing a popular Federal Reserve-sponsored financing program into the spotlight.

Money-market fund assets are increasing at a record clip. Much of that cash is making its way to the Fed’s overnight reverse repurchase facility, which borrows from money funds and other firms in exchange for securities such as Treasurys and then returns the money the next day.

The program, known on Wall Street as reverse repo, allows financial firms and others to earn interest on large cash balances. But some analysts contend it also is effectively draining funds from the banking system, where it otherwise could be invested or lent out.

As of Wednesday, more than $2.2 trillion sat in the Fed’s reverse repo facility, paying a 4.8% annualized rate. That is well above the rates on offer at most banks.

Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

Some analysts are suggesting the Fed should change the terms of the facility to limit further bank distress. Any policy discussion is potentially complicated by factors including the Fed’s effort to raise interest rates to control inflation, and officials have indicated in the past that they prefer to allow market forces to work.

“Every day, firms are handing us over $2 trillion of liquidity they don’t need,” said Fed Governor Christopher Waller during a moderated discussion in January.

Bank deposits have fallen $363 billion to $17.3 trillion since the beginning of March, Fed data show. Assets in money-market funds have risen $304 billion to a record $5.2 trillion, according to Investment Company Institute data.

More than 40% of money-market fund assets are invested in the reverse repo facility, which the Fed created 10 years ago to lift interest rates with a banking sector that had been flooded with reserves.

Roughly $2 trillion or more has been parked there since mid-2022. Demand exploded in 2021, when the Fed’s aggressive stimulus during the Covid-19 pandemic sent a wave of deposits into the banking system.

Use of the Fed facility hasn’t changed significantly in the weeks since the early March failures of Silicon Valley Bank and Signature Bank, but some analysts said banking-sector stresses have made it harder to predict how the central bank’s relatively new tools will influence overnight lending markets.

“What’s different this time is the money-market funds aren’t really as good at recycling money back into the banking system,” said William Dudley, who was president of the Federal Reserve Bank of New York from 2009 to 2018.

Banks have been unwilling to hold extra reserves—or liquid, readily available cash—at the Fed because of a decision that regulators made last decade, Mr. Dudley said.

They chose to count those balances toward banks’ calculation of a key regulatory buffer known as the supplementary leverage ratio, he said.

Officials temporarily exempted reserves from the leverage ratio for a year from April 2020, as the pandemic put extreme stress on the financial system. Reverse repo demand began rising shortly after the one-year suspension of the rule ended.

The treatment of reserves in the leverage ratio “is a reason why some large banks in particular don’t want more reserves,” said Mr. Dudley.

To reduce the amount of cash sitting at the Fed each night, central bankers have a few options. One way would be to cut the rate paid to money funds, analysts said.

Flight To Money Funds Is Adding To The Strains On Banks #GotBitcoin

“To reverse the giant sucking of the overnight reverse repo facility, all the Fed needs to do is lower the interest rate it pays,” said Bill Nelson, chief economist at the Bank Policy Institute—a Washington, D.C.-based trade group—and a former Fed staffer.

In June 2021, the Fed raised the overnight reverse repo rate by 0.05 percentage point. With interest rates near zero, money-market funds were struggling to cover their operating costs, putting a vital part of the financial system at risk. The rate also serves as a floor on short-term interest rates.

With rates well above zero, the Fed has the option to push the overnight reverse repo rate back down to the lower end of the federal-funds target range.

That would need to coincide with the Fed’s raising the rate it pays on bank reserves, according to Mr. Nelson—a move that could encourage money funds to lend to banks rather than the Fed. Interest on reserves is currently 4.9%.

Other analysts said it wouldn’t be appropriate for the Fed to reduce the interest rate on the reverse repo facility to provide relief to banks that have been slow to raise deposit rates.

The facility has been meeting its core objective of “providing highly effective control of overnight interest rates,” said Brian Sack, a former senior executive at the New York Fed who helped design the facility.

“I don’t think the Fed should be trying to force savers into bank deposits by making the alternatives less attractive. I don’t see reducing the reverse repo rate as an appropriate policy step.”

Greater competition among banks would tend to raise borrowing costs and hurt profits. That is a dilemma for bankers that was largely absent in the recovery from the 2008 financial crisis.

Overwhelmed with deposits following monetary stimulus, many banks have chosen not to pay customers higher rates, even when the Fed raised them.

“Banks are still losing deposits, but it’s mostly small potatoes relative to the roughly $17 trillion in total deposits,” said Noor Menai, president and chief executive of Los Angeles-based lender CTBC Bank USA and advisory board member of the Federal Reserve Bank of San Francisco. “Absent any more bad news or unforeseen market events, the banking system is stable.”

Fed officials have said they expect reverse repo balances to decline as they drain reserves from the banking system by shrinking their asset holdings.

If the balances don’t decline, central bankers could bump up against their goal that “ample reserves” remain floating around the banking system and raise questions over whether to prematurely end the portfolio runoff program.

Officials have signaled they would like to avoid that outcome. Federal Reserve Bank of Dallas President Lorie Logan, who helped design the facility as a senior executive at the New York Fed, called for patience in waiting for market forces to move reserves around the system.

“The process of redistribution from the overnight reverse repo facility to banks won’t necessarily be perfectly smooth,” she said in a January speech.

Updated: 4-6-2023

Stocks Haven’t Looked This Unattractive Since 2007

The allure of shares dimmed when bond yields surged and the corporate-earnings picture continued to darken.

The reward for owning stocks over bonds hasn’t been this slim since before the 2008 financial crisis.

The equity risk premium—the gap between the S&P 500’s earnings yield and that of 10-year Treasurys—sits around 1.59 percentage points, a low not seen since October 2007.

That is well below the average gap of around 3.5 points since 2008. The reduction is a challenge for stocks going forward. Equities need to promise a higher reward than bonds over the long term. Otherwise, the safety of Treasurys would outweigh the risks of stocks losing some, if not all, of investors’ money.

The allure of stocks dimmed recently when bond yields shot higher and the corporate-earnings picture continued to darken.

The Federal Reserve now faces the dual challenge of raising interest rates to cool inflation while reaching into its toolbox to prevent a full-blown banking crisis from erupting—both of which cloud the outlook for stocks.

The S&P 500 has clawed back some of last year’s 19% decline, rising 6.5% in 2023. The Bloomberg U.S. Aggregate Bond index has jumped 3.9%, boosted by an early-year rally and higher yields.

Bonds are offering a “once in a generation opportunity, but not once in a lifetime,” said Tony DeSpirito, BlackRock Inc.’s chief investment officer of U.S. fundamental equities.

The current equity risk premium is closer to the longer-term norm: The average premium since 1957 is around 1.62 points, BlackRock research shows. That means stocks should still offer a better return than bonds given their historical outperformance, Mr. DeSpirito added.

The equity risk premium falls when bond yields rise, or a stock’s price/earnings ratio jumps—either due to weaker earnings or higher stock prices. The earnings yield, meanwhile, is the ratio of profits from the past year to current stock prices.

October 2007 would turn out to mark a precarious time in markets. Stocks had recently hit their highest level on record, and the federal-funds rate was near its current level at around 4.8%.

Over the following year, the S&P 500 would go on to drop roughly 45%, and the Fed would cut rates to near zero. Bloated stock valuations reset; bond yields cratered. By March 2009 when the stock market bottomed, stocks’ premium over Treasurys had risen above 7 points and a new bull market was born.

Stocks look pricey again today, and markets and the economy are facing a new host of challenges. By at least one valuation measure, U.S. stocks are currently more expensive than those of any other country or region, Research Affiliates’ data show.

That is based on the S&P 500’s price level relative to inflation-adjusted corporate earnings over the past 10 years, or the CAPE ratio.

Although well off prior peaks seen in the late 1990s and during the exuberance that followed the onset of Covid-19, the U.S. stock benchmark now trades at a multiple of 28.3, pricier than it has been more than 90% of the time since 1881.

Valuations have historically plummeted during economic recessions, though some analysts say lofty valuations won’t prevent stock prices from continuing to rise.

“We have seen the peak for stock-market valuations, but that doesn’t necessarily mean we’ve seen peak prices yet in this cycle,” said Jawad Mian, founder of macro-advisory firm Stray Reflections.

The economy is much more resilient to high interest rates than it has been in the past, said Mr. Mian. High nominal growth—boosted by inflation—will continue to support earnings more than Wall Street’s consensus currently sees, preventing a significant drop in stock prices, he said.

Analysts expect earnings among companies in the S&P 500 to edge up roughly 1.6% in 2023, according to FactSet. At the end of last year, they were calling for a 5% increase.

Since 1957, equities have beaten out fixed income more than two-thirds of the time when they were held for at least a year, BlackRock research shows. Stocks’ favorability improves as holding periods lengthen.

Focusing on stocks’ slim risk premium misses part of the picture, Mr. DeSpirito of BlackRock says. Fed intervention—suppressing short-term rates and buying up long-term bonds—created an abnormal risk-reward profile for stocks after the 2008 financial crisis. He encourages investors to seek stocks with resilient margins and strong earnings growth, while avoiding overvalued companies.

Some investors say frothy valuations mean value stocks—those trading at a discount to their book value, or net worth—warrant consideration.

Value stocks are “dirt cheap” relative to growth, now more discounted than they have been four-fifths of the time in U.S. stock-market history, according to Rob Arnott, founder and chairman of Research Affiliates.

Although value stocks trumped their growth-oriented peers during last year’s rout, growth stocks are back in the lead. The Russell 3000 Growth Index has jumped 12% in 2023 while the Russell 3000 Value Index has remained relatively flat.

When inflation has run between 4% to 8% a year, value stocks have outperformed their growth peers by 6 to 8 percentage points annually, Mr. Arnott said. Consumer prices rose 6% in February from the year before, the smallest increase since September 2021.

“Inflation is wonderful for value,” he added.

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