Fed’s Bank Term Funding Program Gains Traction Amid Rate-Cut Expectations

Quiver Quantitative – The Federal Reserve’s Bank Term Funding Program (BTFP), initially launched in March to support banks during the banking crisis, is seeing renewed interest due to the central bank’s recent dovish pivot and growing expectations of interest rate cuts. The BTFP, designed to provide short-term loans to banks and credit unions against Treasuries and agency debt as collateral, has become increasingly attractive as the prospect of rate cuts in 2024 makes its rates more competitive.

Usage of the BTFP, which allows borrowing for up to one year at a rate slightly above the one-year overnight index swap rate, has surged. The facility’s appeal increased as the Fed’s swaps pricing indicated about 140 basis points of rate cuts by December 2024. In contrast to September, when the BTFP rate was around 5.61%, it now stands at a more favorable 4.96%. This rate is lower than the Fed’s discount window rate of 5.5%, leading to a spike in BTFP borrowing from $100 billion in June to $124 billion in mid-December. Analysts from Wrightson ICAP (LON:) anticipate further increases in BTFP usage, especially as the facility is set to expire in March 2024.

Market Overview:
-The Fed’s Bank Term Funding Program (BTFP), initially conceived as a lifeline during the banking crisis, has unexpectedly become a prime borrowing option for banks thanks to dovish central bank signals.
-With rate cuts on the horizon, the BTFP’s fixed rate suddenly looks attractive, driving record usage and sparking arbitrage opportunities.
-This unforeseen twist adds another layer to the evolving narrative surrounding the Fed’s monetary policy and its impact on financial institutions.

Key Points:
-The BTFP offers one-year loans at a rate tied to the one-year overnight index swap rate plus 10 basis points, currently lower than the discount window’s 5.5%.
-As market bets for rate cuts by December 2024 intensify, the BTFP’s appeal grows, with usage hitting a record $124 billion.
-Analysts expect further borrowing before the program expires in March, fueled by the arbitrage opportunity of parking borrowed funds at the Fed for a higher return.

Looking Ahead:
-The BTFP’s transformation from crisis measure to preferred funding source raises questions about its future and potential extension.
-The arbitrage window narrows as rate cuts materialize, but short-term benefits for banks remain.
-This episode highlights the intricate relationship between monetary policy expectations and their unintended consequences for financial markets.

The BTFP’s structure, which allows prepayment or refinancing without penalty, offers banks flexibility and an advantageous position, especially with a downward-sloping yield curve. This setup enables banks to profit from the difference between the BTFP rate and higher rates on short-term liabilities. Furthermore, banks can leverage an arbitrage opportunity by borrowing at the BTFP rate and then depositing these funds in their Fed accounts to earn interest on reserve balances, currently at 5.40%. This strategy has resulted in a notable spread, making the BTFP an attractive option for financial institutions.

However, the future of the BTFP is uncertain. While initially crucial for providing liquidity and preventing bank runs, extending the program beyond its March 2024 expiration could be contentious. It has evolved from a critical liquidity support tool into a rate-arbitrage subsidy for healthy banks, making it harder to justify its extension in the absence of a banking crisis. The Fed’s pivot and the subsequent market reaction have turned the BTFP into an unexpected boon for banks, offering them a lower cost borrowing option amidst shifting monetary policy expectations.

This article was originally published on Quiver Quantitative