That Giant Sucking Sound Is Velocity Leaving The System

By Simon White, Bloomberg Markets Live reporter and analyst

The Fed’s actions to stem the banking crisis are beginning to accelerate the effects of QT, causing money velocity to drop and intensifying the tightening of financial conditions.

In an implicit acknowledgement that policy may have been overtightened, the Fed at its meeting Wednesday hiked rates by 25 bps, but gave the impression it is on the verge of stepping back from further raises.

The rescue of SVB et al has shifted the landscape and compromised moral hazard, and prompted a reorganization of how bank deposits and Fed reserves are spread through the system. Money has migrated to large banks from small ones as the credit risk of the latter is reappraised in the wake of recent lender failures.

The system overall is saturated with reserves. But there is a distributional problem, with three-quarters of domestically-held reserves with the big four banks, while only 10% are with the next 300 largest, according to JPMorgan (and Zero Hedge which first pointed this out weeks ago).

This disconnect showed up in the LIBOR-OIS spread barely going above 20 bps in the midst of the crisis (versus 350 bps in 2008), even though Discount Window use was ballooning.

This is why there’s a good chance that reserves could end up with money market funds. The big banks don’t want the deposits and may, as they have done before, point larger depositors in MMFs’ direction. They offer a higher yield, and even though they’re uninsured, they invest mostly in ultra-safe assets, so they are very low risk.

We only have the data to last week, but MMFs had already been seeing a rise in their assets.

And some of this may already be finding its way to the RRP facility, which yesterday rose to its high for the year.

With the overnight RRP facility offering ~15 bps more than a 3-month Treasury bill after Wednesday’s rate hike, there’s a strong likelihood that MMFs will continue deposit cash there.

We’ll find out how bank deposits have moved around when the data comes out this evening in the Fed’s H.4.1 release, but in the coming weeks and months we are likely to see reserves leaving the high-velocity world of smaller banks, where they were being lent out more, to the effectively zero-velocity black-hole of the RRP.

Moreover, the Treasury may soon start to build back up its account at the Fed, a further suck on reserves and velocity.

It’s hard not to think conditions are going to get much tighter from here on out, making the Fed’s more cautious stance look prudent.