Banking Woes Continue as Investors Prefer Money Market Alternatives to Bank Deposits.
Hello friends. A warm welcome to new readers and subscribers. I am glad you are here!
In a bid to fight inflation, the FED, amongst other reserve banks worldwide have increased interest rates, exposing the fragility of some banks with inadequate risk management, overall, leaving the US banking system with a significant outflow of deposits and potential spillover effects in other regions. For these intermediaries, customer deposits form a critical component of the interest rate arbitrage revenue stream, when deposits flee, it's a bad omen. Where are we and how did we get here?
In recent times, we have observed unprecedented inflation prints on a global scale, reminiscent of the great inflation period that occurred in the late 1970s, and to maintain price stability, as their key mandates, reserve banks have in tandem canonballed some of the most aggressive interest rate hikes to reduce money supply (high interest rates incentivise savers to save, and penalize borrowers, resulting in less money chasing already supply impaired goods and services). See the chart below of short term interest rates in Euro area, the US and SA. Sharp, steep increases!
source - Kusa Nkosi
The US Federal Reserve Bank is at the forefront of short-term interest rate hikes, reflecting its unwavering commitment to achieving price stability. However, it is widely acknowledged that such aggressive measures may not be sustainable in the long run and could lead to a potential breakdown in the system and as usual, the banks are the first domino to fall. While certain banks have faced consequences due to poor risk management, the larger trend in the US banking industry is the growing preference for money market funds (MMFs) as a viable alternative to traditional bank deposits among investors.
Money market funds that track short dated (less than 12 months maturity) bond yields and other short term instruments (Mortgage Backed Securities) are currently offering higher yields than bank deposit facilities due to their strong positive correlation with reserve bank interest rates. MMFs returns are currently around 5% PA while banks are offering 2% or less. MMFs in the current landscape provide a liquid, high yielding and lower risk alternative to bank deposit in the US.
Source - Goldman Sachs Asset Management
Source - The Macro Compass
In response to the growing preference for money market funds as a substitute for bank deposits, banks are faced with a difficult choice of either raising deposit interest rates to remain competitive and preserve liquidity or raising funds in the capital markets. However, either option presents significant challenges. Increasing deposit interest rates will threaten future income margins and profitability, which may not be a viable long-term solution. On the other hand, raising funds in the capital markets may be more expensive, factoring in a high cost of capital and a high-risk premium due to current market conditions
AT1 equity convertable bond yields as one form of access to capital have more than tripled in light of market conditions, meaning it is more than three times more expensive today to raise capital reserves (liquidity) funds for banks using this instrument than it was a year ago.
Source - Bloomberg
“Only when the tide goes out, do you discover who has been swimming naked.” -Warren buffet. Banks have been swimming naked, as always, they are bending to the fed hike, and a whole lot of second order effects will come into play, ultimately this is deflationary in nature and likely a key inflection point for interest rates to start coming down.
Talk to you soon!