As we noted on several occasions in the past ten days, as a result of QE3 and its imminent transformation to QE4, which will merely be the current monetization configuration but without the sterilization of new long-term bond purchases, the Fed's balance sheet is expected to grow by over $2 trillion in the next two years. This also means that the matched liability on the Fed's balance sheet, reserves and deposits, will grow by a like amount. So far so good. However, as Bank of America points out today, there may be a small glitch: as a reminder on December 31, 2012 expires the FDIC's unlimited insurance on noninterest-bearing transaction accounts at which point it will revert back to $250,000. Currently there is about $1.6 trillion in deposits that fall under this umbrella, or essentially the entire amount in new deposit liabilities that will have to be created as a result of QEternity. The question is what those account holders will do, and how will the exit of deposits, once those holding them realize they no longer are government credit risk and instead are unsecured bank credit risk, impact the need to ramp up deposit building. One very possible consequence: negative bill rates as far as the eye can see.
The chart below shows that notional of deposits backed by FDIC unlimited insurance:
Bank of America opines below, by first presenting the balance sheet dynamics of QE, which by now should be familiar to everyone:
QE leads to growth in bank deposits…
The expansion of the Fed’s balance sheet has important knock-on effects on the size and composition of private balance sheets. When the Fed buys securities, it credits the account of the clearing bank used by the primary dealer from whom the security is purchased with newly minted electronic money (reserves). The dealer’s balance sheet thus sees a decrease in securities holdings and an increase in deposits at its clearing bank; the clearing bank sees an increase in deposit liabilities and an increase in reserves held at the Fed; and the Fed sees an increase in reserve liabilities and an increase in securities holdings.
Who ultimately holds these bank deposits – and which banks hold the excess reserves – is determined by many subsequent transactions. But for the banking system as a whole, the Fed’s purchases force an increase in deposit liabilities (or in some cases liabilities such as repo, fed funds, CDs, etc) as well as holdings of excess reserves, all else being equal. This pattern holds true as long as the seller of securities is not a bank, in which case the bank simply swaps securities holdings for reserves without any effect on its deposit liabilities. Excess reserves stand at roughly US$1.5tn as a result of the Fed’s prior asset purchases, while banking system deposits have increased by an even larger amount since late 2008.
However, the natural growth of deposits may be impacted due to the FDIC cliff at the end of the year:
Depositors whose balances have grown as a result of QE1 and QE2 have had access to noninterest-bearing accounts with unlimited FDIC insurance, which was introduced in October 2008 to improve the funding position of FDIC insured banks (for details see US Rates Viewpoint: Beware the $1.6tn deposit insurance cliff). The availability of unlimited FDIC insurance coverage of noninterest-bearing transaction accounts has represented an elastic supply of risk-free assets that have grown to US$1.6tn over the past four years. The Dodd-Frank Act extended this coverage through end-2012.
However, December 31, 2012 will see the expiration of unlimited FDIC insurance on noninterest-bearing transaction accounts unless Congress takes action to extend it, which appears unlikely. If the provision expires as scheduled, the FDIC coverage for these deposits will revert to the standard US$250,000 limit. Upon expiration, depositors will be forced to choose between moving their cash elsewhere and accepting that their deposits will be converted from government credit risk to unsecured bank credit risk.
And since when it comes to the decision of counterparty risk and cash holdings, nobody will pick a bank, which may or may not be insolvent, book value metrics aside, over Uncle Sam, it is quite likely that most will opt for short-term bonds which are rolled month after month even though they collect no interest. This means a substantial reduction in the outstandinf total deposit base of nearly $9 trillion.
Putting it all together:
QE3 and the deposit insurance cliff
Because many depositors are highly risk averse, we expect that a portion of the US$1.6tn in fully insured deposits in accounts with more than US$250,000 in balances will leave banks for the relative safety of money market funds and direct holdings of Treasury and agency securities. This could result in negative bill yields and wider 2y swap spreads, in our view. However, deposits of the banking system as a whole will likely not decline when this provision expires, though there may be dislocations for individual banks.
Instead, the US$2tn in Fed QE purchases that we expect over the next two years will increase the overall supply of bank deposit liabilities over time. But, unlike QE1 and QE2, the deposits created by QE3 will only be FDIC insured up to US$250,000 per account. As a result, risk-averse investors will likely bid up the price of short-dated Treasuries until the market is indifferent between holding uninsured deposits and holding Treasury bills at much lower yields. This effect will likely become more pronounced as excess liquidity in the system increases, as well as during episodes of risk aversion, when bank CDS spreads tend to widen.
In other words, prepare for negative bill yields coming soon to an indefinite future near you as unintended consequence #1293834.5 of the Fed's takeover of every market slowly materializes. At least the Treasury will soon be able to issue bonds at negative yields in the primary market as had been discussed previously. Indeed, that TBAC committee led by the new head of JPM's CIO Matt Zames, truly knows what is going on months ahead of the market (recall "Supercommittee That Runs America" Urges End To The "Zero Bound", Demands Issuance Of Negative Yield Bonds") . As to what other unexpected consequences materialize once $1.6 trillion in cash moves from point A to point X, we will all just have to wait and see.