Banks were far more hesitant to invest cash in the bond market in the first quarter of 2022 ahead of the Federal Reserve rate hikes, and that decision may have proved wise given the sharp increase in rates in the months since.

While excess liquidity grew on bank balance sheets in the first quarter as deposits increased at a slightly faster pace than loans in the period, bank securities portfolios rose just 0.2% from the prior quarter. As a result, bonds dipped to 26.1% of assets from 26.3% of assets in the prior quarter, according to S&P Global Market Intelligence data.

Banks put less cash to work in the bond market

Banks' cash deployment in the bond market slowed considerably in the first quarter as institutions braced for higher interest rates and the prospect that tighter monetary policy could put some pressure on liquidity. The Fed raised short-term rates in mid-March and signaled early in the first quarter that it planned to act more aggressively in 2022 to temper elevated inflation. The Fed has raised short-term rates another 125 basis points since the end of the first quarter, with a series of hikes in May and June.

Intermediate rates have risen considerably through late June as well, with the yields on the 2-year, 3-year and 5-year Treasuries increasing more than 100 basis points since the end of the first quarter. The surge in rates has come on top of strong increases in yields in the last few weeks of March.

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Ahead of the sharp increase in rates, banks deployed less cash toward the long end of the yield curve, perhaps recognizing that the values of those securities would come under greater pressure if interest rates rose. Bonds expected to reprice or mature in more than 15 years nearly held steady from the prior period, while bond portfolios grew modestly. Accordingly, those longer-term bonds dipped to 34.6% of bank-held securities in the first quarter from 34.7% in the prior quarter.

Banks staying on short end for now

Banks continued to allocate more purchasing activity to shorter-term securities in the first quarter. Securities expected to mature or reprice in less than three years rose 2.1% in the first quarter from the prior period and climbed 13.1% from year-ago levels. With the increases in positions, shorter-term securities climbed to 22.4% of total securities from 22.0% in the prior quarter.

Increases in rates put pressure on the values of many bonds banks owned in the first quarter, and additional increases in rates in recent months suggested that values could come under greater pressure in the second quarter. Banks that kept their powder dry or at least invested in short-term securities likely mitigated some of that pressure and had the opportunity to put funds to work at higher yields.