CNBC Guest Blog

Published: Friday, 30 Oct 2009 | 10:52 AM ET

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Andrew Busch
Global Finance Strategist
BMO Financial Group

It's called carry, but not like currency carry. As most know, banks can fund themselves at 0.1%-0.25% as the Federal Reserve keeps Fed Funds at 0.0%-0.25%. Then banks are incentivized to find the safest, highest return they can with this cash.

Now, the US Treasury and the Federal Reserve hope that this low cost of funding to banks would make lending more attractive and incent banks to make new loans. As the Fed loan surveys show, this is now occurring and new lending is not being generated. This is a phenomenon that is not only occurring in the United States, but also in the UK as there loan surveys show the same drop in loan volume.

woodleywonderworks Treasury Building

This is not that surprising given that banks continue to have to set aside loan loss reserves for commercial real estate and loan defaults by small and medium-sized U.S. businesses rose in September to 0.85% from 0.81% in August.

This means that while the US economy is improving that banks are still facing headwinds with previous loans that were made during the last 3 years.

Then where is this cheap money going?

Why back to the US Treasury!

Banks earn a somewhat risk free return on their cheap money from the Fed by purchasing US Treasury securities. Depending on where they buy on the yield curve, they may earn 30 bps for 1yr, 75 bp for 2 years, and a whopping 210 bp for 5 years. They fund these positions by borrowing from the Fed at 0.1-0.25%.

But there's one more big incentive for banks to do this carry trade. If they buy something other than Treasury securities, they have to set aside a percentage of the assets value based on the risk weighted asset rating. This carry is only limited by what regulators will allow the bank's leverage ratios to reach.

As a matter of fact, this carry situation is exacerbated by regulators telling banks to increase their tier one capital ratios. You can do this by either adding capital by issuing shares or generating profits/retained earnings, or by bringing your risk weighted assets down – the most RWA consuming assets generally are loans. Guess what is the easiest for banks to do?

As the world looks to see how the massive US Treasury auctions are going, don't be fooled into thinking that the US government can easily fund itself because the markets have confidence in defect reduction down the road. As the economy recovers and the business environment shifts, this bank-Treasury carry trade incentive will be reduced as the Fed raises interest rates and the cost of funding the carry goes up.

Therefore, the appetite for US government securities will be reduced as well and we'll get a much better view of how the world feels about the US massive fiscal deficits.

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Andrew B. Busch is Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him here and you can follow him on Twitter at http://twitter.com/abusch .

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