US banks slow cash deployment in bond market as deposits drop in Q2

Even in the face of higher interest rates, banks were hesitant to invest cash in the bond market in the second quarter of 2022 as deposits declined in the period.

Bank securities fell 1.8% from the prior quarter as excess liquidity declined in the period, with loans growing 3.7% from the linked quarter and deposits decreasing 1.9%. As a result, bonds dipped to 25.9% of assets from 26.1% in the prior quarter, according to S&P Global Market Intelligence data.

Bank investing slows as liquidity pressures emerge

Banks escalated bond-buying activity after the start of the pandemic as government stimulus and accommodative fiscal policy left them awash in deposits. But banks deployed less cash in the bond market in the second quarter as elevated inflation and the Federal Reserve's efforts to tame it through tighter monetary policy began to put some pressure on liquidity.

The Fed raised short-term rates another 175 basis points in the second quarter through a series of rate hikes in April, May and June and began shrinking its balance sheet late in the period. The central bank increased the target fed funds rate by 75 basis points in July, and Fed funds futures suggest that another 75 basis points hike is in the offing at its Sept. 21 meeting.

Intermediate and longer-term rates have followed rate hikes, with the average yields on the 2-year, 3-year and 5-year Treasurys increasing more than 110 basis points in the second quarter from the first quarter. Those yields have continued to rise in the third quarter.

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Banks continued to allocate less cash toward the long end of the yield curve in the second quarter, recognizing that the values of those securities could come under greater pressure as rates rose. Bonds expected to reprice or mature in more than 15 years nearly fell to 33.8% of bank-held securities in the second quarter from 34.6% in the prior quarter and 36.2% in the year-ago period.

Banks deploy more cash in shorter-term investments

While total securities declined in the second quarter, banks continued to increase their exposure to the short end of the yield curve in the period. Securities expected to mature or reprice in less than three years rose 2.5% in the second quarter from the prior period. With the increases in positions, shorter-term securities climbed to 23.4% of total securities from 22.4% in the prior quarter.

Increases in rates put pressure on the values of many bonds banks owned in the second quarter, weighing on tangible book values. Shorter-term and intermediate rates have grinded higher since the end of the second quarter and many banks have opted to invest more funds in short-term securities to avoid that pressure and maintain access to those funds sooner in the event that liquidity pressures accelerate.