The 2-Year Treasury sold off heading into last month’s Federal Open Market Committee (FOMC) meeting, and its spread over the Fed funds rate widened on expectations that Kevin Warsh’s seating as chairman would usher in a new era of Fed hawkishness. The yield fell back (Slide 1) after he and most of the committee voted to keep rates stable. Weak unemployment data following the vote, along with more evidence that core inflation might be cooling post-meeting, further took the momentum out of the thesis that the Fed is about to get tougher on inflation. Committee members who dissented, and even some who voted with the majority, said after the meeting that their patience with persistent inflation is running out, but markets appear to be fading the odds of a September hike or any hike this year.

Bank treasurers began the year expecting interest-rate relief from the Fed to help them recover the market value of their bond portfolios, which remain deeply underwater (Slide 2) after the Fed raised rates in 2022 and 2023. Today, however, with or without a rate hike this year, they increasingly worry that the long end of the yield curve, on which Agency Mortgage-Backed Securities are priced in secondary markets, will steepen and prolong the pain in their bond portfolios. On the other hand, as the Fed held front-end interest rates steady, the banking industry has been able to reinvest runoff into higher-yielding earning assets, which helped raise its average net interest margin to its highest level since 2012 (Slide 3).

The Fed announced this month that it would not make additional purchases of Treasury Bills (T-Bills) under its Reserve Maintenance Purchase program until October. Its T-Bill portfolio in its System Open Market Account (SOMA) totals $538 billion, up from the new year, lowering the portfolio's weighted average maturity from 9 to 8 years (Slide 4). Reserve deposits continue to average about $3 trillion (Slide 5). The Fed began earning more interest income on SOMA than it pays out to banks as interest on reserves this year, the first time since 2022. Consequently, the balance of cumulative negative Treasury remittances, which sits on the liability side of its balance sheet, is falling, adding downward pressure on the balance of reserve deposits (Slide 6).

The massive deficit spending that ballooned the national debt to over $39 trillion this year flowed into the money supply, fueling inflation in grocery prices and boosting bank deposits to record levels (Slide 7). This, in turn, helped fuel the banking industry’s growing investment in nonbanking depository institutions (Slide 8). It also pushed up the value of tangible assets; for example, the price of farmland increased by 50%, to $4,500 per acre, over the last five years, even as crop yields declined (Slide 9).

Primary dealers scaled out of Treasury repo last month, in July (Slide 10), which could reflect hedge funds rotating out of technology risk exposures.