Access to high-quality liquid assets (HQLAs), such as short-term government securities like U.S. Treasury Bills, is a critical component to bank lending activity. Banks need collateral for several reasons, but we tend to track demand for collateral because of its importance to banks when it comes to credit formation. Banks’ ability and willingness to lend has historically driven economic activity, thus a slowdown in that ability or willingness has negative implications for the broader economy. Credit formation tends to slow when accessing cash and collateral becomes more difficult.
The starting point for willingness to take risk and expand balance sheet capacity is in the collateralized lending market. There are ways to measure interbank stress and global monetary conditions that provide insight into the current setup. The most widely accepted and utilized collateral is short-term government securities, with U.S. Treasuries Bills being the most liquid and most used. When demand for this collateral is accelerating, we tend to see increased utilization of various interbank lending programs. Primary Dealer activity, Federal Home Loan Bank advances, Discount Window usage, and new facilities like the Bank Term Funding Program are examples of data we can track for a view into the collateralized lending market.
Primary Dealer fails (one party fails to deliver or receive collateral) can be used as one measure of interbank stress. When a borrower fails to receive, the lender is unwilling or unable to meet the collateral needs of the borrower. On the other side of that transaction, if the borrower fails to deliver, the borrower is unwilling or unable to return the borrowed collateral to the lender. Either outcome occurring at elevated levels over several weeks points toward rising collateral demand and interbank stress. Over the last few weeks, Primary Dealer fails have been increasing.
Another collateral source for primarily small to mid-sized banks comes from the Federal Home Loan Bank. In the latest release, FHLB advances were at $824 billion. A recent report from Bloomberg suggests this number may increase by as much as $304 billion to $1.12 trillion in the next release, which would be a record high level.
Depository institutions utilizing the Discount Window has also increased to record levels, hitting $153 billion two weeks ago and $110 billion last week. The purpose of this program is to provide access to funding and support the liquidity needs of the banking system. An increase of this magnitude suggests there is strong demand for liquidity. In addition to the Discount Window, the Federal Reserve announced an emergency lending program coined the Bank Term Funding Program (BTFP), which increased to $54 billion last week.
The takeaway is that each of these measures is indicating the same lack of normal interbank lending activity.
There is also evidence of this lack of collateral in market-based indicators. Looking at U.S. Treasury Bill yields relative to Repo Rates and the Federal Funds Rate, we can see how much demand there is to own HQLAs. In a normal market environment, U.S. T-Bills yields should be higher than the Repo Rate and the Fed Funds Rate. Today, the 1-Month is 56 basis points lower than the Repo Rate and 76 basis points below the Fed Funds Rate. The 3-Month is in-line with the Repo Rate and 20 basis points lower than the Fed Funds Rate. Moving out on the curve, we see all yields trading below the Fed Funds Rate with only the 6-Month above the Repo Rate.
We can also look to Treasury Auction results for more evidence of collateral demand. The low rate of 4-Week T-Bills came in at 0% over the last two weeks. The same 0% low rate showed up in the 8-Week T-Bill auction over the last two weeks. Both of these auctions signal a willingness to pay a premium and forgo any return you would get from the secondary market, to own this asset.
Source: Treasury Direct.
Moving to the foreign setup for collateral, we are also seeing government yields below their respective policy rates. To highlight a few, Canada, Germany, and the United Kingdom are experiencing that dynamic. These are utilized less on a global basis compared to U.S. Treasuries, but the signal is the same – increased demand for HQLAs.
The biggest takeaway from these developments is the longer-term implications for economic growth and inflation. Historically, credit growth creates real economic growth and ultimately is the driver of inflation in the long term. When banks are increasing their own liquidity, they are less likely to be providers of liquidity which has negative implications for credit growth and economic activity moving forward.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Economic Analyst
Boyd Watterson Asset Management, LLC