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The above-normal CD-OIS spreads January to March, which pushed up lending rates, were ascribed to heavy issuance of CDs. This is an incomplete explanation: the right question is why CD demand did not respond adequately to higher rates. We believe policy has not adjusted adequately to two major shifts in the financial system that make 2-3% of system liquidity effectively unavailable for lending: i) government cash balances are 1% of NDTL higher and 0.5% of NDTL more volatile post-2020; ii) across debt and equity MFs, TREPS balances are 1-2% of NDTL: these are not deposits, and banks cannot build assets with them. We explore some options for policymakers.
Much higher than usual CD-OIS spreads Jan-Mar: where is liquidity trapped?
CD-OIS spreads are back to ‘normal’ levels in April, in line with seasonality, but the spike in 3M and 12M CD-OIS spreads Jan to March was well above seasonal and began much earlier than usual. Many ascribe this to heavy CD issuance in Nov‑25 and Feb‑26, with gross CD issuance hitting an all‑time high. That said, this is unlikely to be the dominant factor, with rates having normalised. The deeper questions are – why CD demand did not respond to prices, and where liquidity is trapped.
TREPS liquidity is ‘trapped’; Govt. cash balances higher and more volatile too
With corporates’ share of incremental deposits rising and current account ratios flat, additional savings flow to banks either directly via non-retail term deposits (NRTD), or indirectly as CDs via debt mutual funds, which hold 87% of CDs. Debt MF AUMs (funds mostly from corporates/HNIs) are now 5.5% of NDTL, vs. 3.3% in 2018. As CDs also affect NRTD (8% of NDTL vs. 3% in 2018) rates, their impact on rate transmission has risen.
The share of CDs in debt MFs has risen to a 10Y high 26% (vs. 10-15% levels pre-Covid). For liquidity, Money Market funds (70% of debt MF AUM) keep 35-40% of AUM in TREPS and T-bills. Across debt and equity MFs, TREPS balances are 1-2% of NDTL. They don’t show up as deposits and have limited utility for banks in building assets.
In addition, government cash balances are now 1% of NDTL, and much more volatile. 2-3% of system liquidity is thus effectively unavailable for lending.
Possible solutions: above ‘normal’ liquidity; more T-bills; MF discount window?
We believe policy has not adequately adjusted to this new plumbing. To handle volatility in government cash balances, Fed researcher suggests: i) ample reserves; and ii) active trading of securities (incl. T-bills). With net liquidity below 0.4% of NDTL on 40% of days, there is a case for ample reserves. More T-bills in deficit financing plans can help too, and a discount window for MFs can also reduce flow into TREPS.
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