Over the past month, we’ve seen US 10 Year Treasury rates decline from a high of 2.60% on March 9th to 2.24% on April 13th. For many investors, this is confusing, as they’ve already come to expect steadily increasing interest rates. As is the case with any market, prices and yields do not move in a linear fashion. Short-term zigs and zags are normal in any market, even though the long-term trend is up or down. This time last year, the 10 Year was around 1.80%. From this perspective, the trend is upward.
There’s some other fundamental market condition that is broadcasting that the higher rates are here to stay. On March 16th, the Federal Reserve raised its interest on excess reserves (IOER) to 1.00%. This follows a steady ratcheting upwards since early 2016, when it was raised from 0.25% to 0.50% for the first time since the Great Recession. The IOER has now doubled from just one year ago. This signifies the Federal Reserve’s confidence that Treasury yields and rates overall will continue higher.
Banks are required to hold capital reserves based on its cash deposits. However, after the 2008 financial crisis, extreme easing on monetary policy created a tidal wave of Treasury debt. The Fed bought trillions of dollars by crediting the sellers with greater reserves at the Fed (via FOMC activity). This is resulted in the excess reserves shown in the chart above. The Fed now pays to banks interest on more than $2.1Trillion of excess reserves, totaling $60Million in interest payments to U.S. banks each day.
In short, the Fed earns interest from the Treasury bonds it holds, but then pays interest to banks on their excess reserves held with them. With the Fed paying a higher rate on these funds, banks have less incentive to loan out the funds to businesses and consumers. Simultaneously, the Fed is reducing their profit margin at this higher interest rate payment to banks, if Treasury rates stay at current levels. With this latest rate increase, the Fed is continuing to prime the pump for further rate hikes.
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