Cash assets held by foreign banks have declined at an even faster pace than those by their US counterparts
[NEW YORK] The effective federal funds rate, which has held near the bottom of the US Federal Reserve’s target range for its benchmark over the past two years, could soon edge higher in a sign that excess bank reserves are dwindling faster than expected.
A combination of factors stemming from the Treasury’s move to increase short-term bill issuance since July is luring funds away from the financial system and putting pressure on ultra-short-term rates.
While fed funds is designed to fluctuate within a 25-basis-point target range, it has barely oscillated over the past two years except when the Fed itself adjusted policy rates, even as other short-term rates have been rising, stirring a debate about which benchmark rate the Fed should be targeting. A move in the fed funds rate higher outside of rate-setting periods would signal some sensitivity to tightening financial conditions.
A move higher is “getting closer sooner than we expected”, Wrightson ICAP senior economist Lou Crandall wrote in a note to clients. He said that market trends suggest the rate “might already be flirting with an uptick from 4.08 to 4.09 per cent”, though the move could still be a few weeks away.
Liquidity has tightened as commercial bank reserves held with the central bank have been dropping. Cash assets held by foreign banks have declined at an even faster pace than those by their US counterparts.
Wall Street strategists are closely watching bank reserve balances, as usage of one of the Fed’s overnight lending facilities, long considered a measure of excess liquidity in funding markets, has dropped to a four-year low.
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A drop in bank reserves, currently just over US$3 trillion, to the lowest comfortable level to prevent market disruptions would force the central bank to intervene. Fed governor Christopher Waller recently estimated that level at US$2.7 trillion.
Once a robust avenue for overnight interbank lending, the fed funds market used to signal when financing conditions were tightening. But massive monetary stimulus during the financial crisis and the pandemic left the country’s banking system awash in US dollars, leading banks to largely withdraw from the fed funds market and park their money directly at the Fed instead.
Transactions underlying the fed funds rate have declined since there’s less surplus money for non-US institutions to deploy in the market, Crandall said. In addition, tighter liquidity has caused a recalibration in the weighted distribution of the unsecured funding rate.
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“Aggregate Fed reserve balances at foreign banks have declined more rapidly and earlier than we expected this month,” he said.
The amount of US dollars that foreign banks are holding dropped for the third straight week, the longest stretch since the beginning of the year.
Strategists are split over how soon the effective fed funds rate will rise. While Crandall sees it ticking up in coming weeks, Citigroup strategists Jason Williams and Alejandra Vazquez Plata said they have yet to see the distribution of reserves shift in a way that would warrant a move higher. But they noted it’s possible the benchmark could rise by one to two basis points towards the end of the year.
Here’s what to watch to when the fed funds rate could possibly shift higher:
Foreign bank cash
Cash assets held by foreign bank organisations have dropped by roughly US$255 billion in the three weeks ended Sep 10 to the lowest level since the end of 2024, according to the latest Fed data.
When foreign banks are flush with cash, they tend to engage in the so-called “Fed arbitrage” – borrowing in the fed funds market and parking that cash at the central bank to earn IORB (currently 4.15 per cent). But as market conditions tighten, overnight borrowing costs in fed funds and Eurodollar markets trend upwards and excess balances from non-US banks begin to shrink.
Fed funds volume
The decline in surplus liquidity from foreign banks has resulted in lower volumes underlying the fed funds rate. Fed funds volumes have not exceeded US$100 billion for about a week after averaging about US$113 billion since late April, according to Wrightson ICAP.
Citigroup strategists expect a “more pronounced drop” in transactions before small domestic banks begin bidding for fed funds, noting that as at 1Q 2025, domestic fed funds volume averaged 7 per cent, well below the 26 per cent average from 2018.
The 75th percentile
Before the Fed lowered its benchmark policy target rate last week, there had already been an uptick in the 75th percentile of the fed funds rate – considered to be a proxy for bank funding costs. While a shift in the distribution tends to signal a move in the median is imminent, such an increase is likely to lag other funding benchmarks like the Secured Overnight Financing Rate.
Bank of America strategists Mark Cabana and Katie Craig wrote last week, that would take one to two weeks of elevated discount note levels shifting versus other money-market rates in order to move fed funds. BLOOMBERG
