As the Fed is in the midst of a rate hike cycle, it seems important to remember why this cycle is like no previous rate hike cycle. The mechanics of this hiking cycle are completely unique and experimental...thus the outcome is far more of an unknown than "normal".
Why? In a typical cycle, the Fed would sell a relatively small portion of its assets...er, balance sheet (typically short duration bills and notes) to banks. This would withdraw some of banks liquid funds (replacing them with less liquid assets) and create "tightness". This tightness would push overnight lending rates higher and the daisy chain of rising rates would work its way through from the shortest eventually all the way to the 30yr Treasury bonds.
However, this time, nothing like that is happening. This is because the Fed sold all its short term notes/bills (in Operation Twist) and bought longer duration MBS (mortgage backed securities) and longer duration Treasuries in Quantitative Easing to the tune of $4.5 trillion. Further, since the Fed bought most of these assets from large banks, these banks held much of the proceeds from these sales at the FRB (Federal Reserve Bank). For the Fed to perform typical rate hikes, it would need to remove most of the $2.1 trillion banks are now sitting on in excess reserves @ the FRB...likely creating a crisis in the process. Conversely, if the Fed can't contain the $2.1 trillion at the FRB, and the reserves are leveraged into the market...stand back in awe of the mother of all bubbles.
Thus, the Fed has instead determined to raise rates via paying banks interest on these excess reserves to maintain the reserves at the Federal Reserve. In short, pay banks not to lend money, not to invest the reserves. This is just like Federal programs that paid farmers not to farm...IOER (interest on excess reserves) pays big bankers not to bank.
Since the end of QE in late 2014, the Federal Reserve has continued to buy bonds with the intent of maintaining a consistent quantity of assets on its balance sheet. But interestingly, banks excess reserves have been declining, by as much as $800 billion since late 2014 (chart below). Apparently, during this Fed balance sheet maintenance phase (as the Fed continues to buy assets from the banks to maintain its balance sheet) banks aren't doing their part and have been unwilling to retain these proceeds as excess reserves.
And a close up of the above chart from 2014 to present (chart below). Since the end of QE, $800 billion previously held in excess reserves found its way into loans and/or markets!!! Considering that much or even the majority of the excess reserves are held by foreign banks, it seems more likely the newly liberated cash would find its way into financial assets. Even conservatively leveraged, that's an awful lot of money (not so conservatively leveraged, it's a big deal)!
Excess reserves held at the Fed declined by almost $800 billion from the end of QE until the Fed began it's more recent set of rate hikes (from 0.5% to 1.25%)...but behold, excess reserves have responded by increasing almost $200 billion (chart below) since the recent set of rate hikes.
Excess reserves held at the FRB appear to have responded to the ramping IOER...just as the Fed intended (chart below)!?!