- Macro Strategist
Asia ex-Japan, Institutional
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When it comes, the tapering and eventual end of the Federal Reserve’s quantitative tightening (QT) program — one of the key tools in the central bank’s battle with inflation — will be good news for financial markets as more liquidity becomes available. But the key question is this: Can the Fed engineer the end of QT without any mishaps for small banks and the equity market as a whole or will bank reserves tighten first, impinging on market liquidity?
The state of QT
The Fed commenced its QT program — a reversal of its crisis-era asset-buying program (quantitative easing) aimed at keeping interest rates down — in June 2022, setting a monthly balance-sheet runoff cap of $60 billion in Treasury securities and $35 billion in mortgage-backed securities (MBS). In aggregate, the Fed has reduced its balance sheet by $1.3 trillion, leaving total assets held at $7.7 trillion as of the end of December 2023. In relation to economic output, the balance sheet has gone from 36% of GDP to 28%.
On the liability side, reductions in the Fed’s balance sheet have come from reverse repos. Assets in the reverse repo facility (which allows eligible counterparties to park cash at the Fed and earn interest) declined from $2.6 trillion at the end of 2022 to $1.2 trillion at the end of 2023. The bulk of that decline came in the second half of 2023, when greater certainty of a peak in the federal funds rate, alongside increased Treasury bill issuance, resulted in some liquidation by money market funds searching for higher yields. At the current pace of decline, reverse repos could be depleted as early as the end of the first quarter of this year or the beginning of the second quarter, which could put pressure on some money market rates — a potential outcome that is starting to catch the attention of members of the Federal Open Market Committee (FOMC) as they contemplate the policy path from here.
What will drive the Fed’s decision? Bank stresses may be high on the list
The Fed’s previous guidance in terms of what it would need to see before ending QT included: 1) get the balance sheet to about 18% of GDP; 2) get excess reserves at banks to about 10% of GDP, which would amount to $2.8 trillion (down from $3.4 trillion at the end of 2023); and 3) keep an eye on money market rates for smooth functioning.
On that third point, some signs of stress began to appear in money markets at the end of 2023. That prompted comments in the Fed’s December meeting minutes and, separately, from Dallas Fed President Lorie Logan (an expert in financial system “plumbing”) and New York Fed President John Williams (the New York Fed is responsible for conducting open market operations under the direction of the FOMC). All of this suggests the Fed will start to think about winding down QT this year. Meanwhile, points one and two above imply that should QT continue past the first quarter of 2024, excess reserves at banks would be the target for QT, which could put additional pressure on banks if rates stay high and deposits flow out from banks to money market funds.
Importantly, the Fed’s bank term lending facility is set to expire in the middle of March, potentially creating uncertainty about the health of banks that still find themselves in a hole when it comes to the collateral value of some assets on their balance sheets. In this context, President Logan’s comments about dispersion within the banking system around reserves may be telling, suggesting that liquidity broadly but also distributionally will be watched for signs of stress.
With this in mind, the Fed’s ability to get the timing of its QT moves right could be quite important to the smooth functioning of markets. The Fed minutes and various Fed speeches indicate a desire to taper QT as a first step and then eventually end the program, all based on the FOMC’s read on the underlying reserve needs of the financial system.
What might tapering look like in practice?
I see a number of potential scenarios that could play out. For example:
- We could see the Fed cut its balance-sheet runoff cap in half in June and then end QT in early 2025, when the balance sheet may be closer to 18% of GDP. This assumes no mishaps occur along the way.
- Given the higher deficit/debt situation in the US since the QT tightening guidance was initiated, as well as changes in the banking system stemming from the regional banking crisis in early 2023, the threshold of 18% of GDP may not be valid anymore, and it is possible that QT ends completely later this year.
- To the extent that President Logan’s comments suggest wanting to leave the reverse repo program in positive territory at the time the Fed begins to unwind QT, that could mean an announcement comes as early as the March FOMC meeting, even if the start date for the unwind is later — but leaving open the possibility that there could be a complete pause in QT at some point in 2024 if more pronounced stresses emerge.
Two additional thoughts on the execution of the tapering: Even after the Fed begins tapering QT, it is likely to leave MBS in runoff mode given that the $35 billion cap has never been binding and the Fed has long expressed a desire to move away from MBS in its portfolio. Another development to monitor will be whether the Fed chooses to reinvest its principal payments into shorter-maturity Treasury securities when the time comes. Over time, this would restore the term premium to the Treasury curve and push longer-term yields higher.
Finally, given the importance of this decision by the Fed to the economy and the markets, I’ll be tracking a number of indicators to gauge the timing of the initial taper, such as relevant money market interest rates, reserves in the banking system, the US fiscal deficit, and flows from money market funds.
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