This Month’s Chart Deck

The Treasury yield curve steepened this month, and for the first time in more than two years, the spread between the 3-month and 10-year Treasury was positive, if just barely at 20 basis points plus or minus as of mid-month. (Slide 1). The yield on the 10-year increased by nearly 100 basis points, to 4.5%, since the Fed began cutting the Fed funds rate last September, which powered the curve out of negative territory. Typically, when the yield curve was steepening before the Global Financial Crisis (GFC), the spread between the front end and the long end of the yield curve tended to peak at close to 400 basis points, but since then, the last time the yield curve went through a steepening phase, the peak spread in 2022 only got as wide as 200 basis points (Slide 2). Given that the Fed just signaled that it was too optimistic last September to cut rates four more times next year, the chances are that the current steepening phase will fall short of even the 2022 peak spread.

Over the past six months, the Secured Overnight Financing Rate (SOFR) has averaged a few basis points over the effective Fed funds rate (Slide 3). In contrast, it averaged a few basis points earlier this year through the unsecured overnight rate. The positive spread may reflect liquidity stress in the repo market because there may be insufficient cash providers to meet primary dealer demand for general collateral financing. The Fed reduced its Reverse Repo Facility (RRP) from $0.8 trillion last June to under $0.2 trillion this month, which should help ease some of the stress in dealer financing. The Federal Open Market Committee also adjusted the RRP rate to match the bottom of the target range for the Fed Funds rate. These actions should help improve the cash supply in the repo market. But reserve deposits remain very abundant at $3.4 trillion.

When assets on the Fed’s balance sheet, such as the System Open Market Account (SOMA), increase, reserves increase dollar for dollar. However, when a liability on the Fed’s balance sheet increases, reserves decrease dollar for dollar. Most liabilities on the Fed’s balance sheet, such as the Treasury General Account and the RRP, can increase or decrease over time, decreasing or increasing reserves accordingly. However, Currency in Circulation can only increase; it never decreases. In September 2019, when the repo market suffered a severe financing shortage, and SOFR jumped by 300 points overnight, there was more currency in circulation than there were reserves on deposit at the Fed (Slide 4). The Fed’s paper money liability was growing at 4% a year at the time, contributing to the downward pressure on reserves because there was more paper money, at $1.8 trillion, than reserves, at $1.4 trillion. So, a 4% increase in currency would produce a 5% decrease in reserves. In the last five years, however, currency in circulation grew by only 1% a year, and equal to $2.4 trillion today, it is still $0.9 trillion smaller than the balance of reserves, at $3.4 trillion.

Bank treasurers reported that deposit outflows stabilized and are beginning to reverse, but the money market funds have been growing at their expense (Slide 5). These pressures encourage consolidation, especially among community banks with assets under $10 billion. Thus, FDIC-supervised banks fell from 4,700 in 2010 to 2,800 in 2024 (Slide 6). While the number of state-chartered banks in the U.S. might out-number the number of OCC-chartered banks by more than 3-to-1 (Slide 7), on September 30, 2024, the 906 Nationally-supervised bank total assets equaled $15 trillion, compared to the $7 trillion of total assets owned by state-chartered banks (Slide 8). Not only are banks buying other community banks, which drives the depletion of their ranks, but credit unions are also acquiring community banks as M&A transactions at a record pace (Slide 9).

Before the GFC, investors in de novo banks were opening more than 100 a year. Since the GFC, the average number of de novo bank openings has been five a year, with only two new banks through the first nine months of 2024. M&A transactions between banks fell off in 2023 and got worse this year, with just 55 transactions in 2024, compared to 100 in 2023 and 145 in 2022. The pace of M&A activity between banks would be faster, except that many prospective sellers are sitting with deeply underwater fixed-rate assets that a buyer would need to mark to market and realize the loss up front on the day of sale (Slide 10). Regardless, with 55 banks that merged and only two new banks that opened, the community banking industry looks set to continue to shrink its ranks next year.