(Bloomberg) -- 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.
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.
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.”
