The Fed’s shrinking balance sheet is worrying major segments of the U.S. financial markets.
For participants in overnight money markets, a key conduit for bank borrowing and key to setting interest rates, Wednesday’s policy meeting included a more relevant message from Chairman Jerome Powell than the one that sent stocks surging and the U.S. 10-year yield below 4. %: In other words, the Fed’s balance sheet shrinkage will continue as planned.
Debate is simmering over whether the Federal Reserve is misjudging how much it can shrink its balance sheet – a process known as quantitative tightening – without causing chaos in places like the repurchase agreement markets, which are part of the financial system’s vital plumbing. The recent stress has seen one benchmark interest rate hit a record high, bringing back memories of September 2019, when other overnight market rates soared 5x to 10% and central banks were forced to intervene.
While the recent disruptions were actually much less severe than those of four years ago and did not require intervention, both episodes shine a light on the increasingly delicate balance between the Fed, banks and other institutions that help keep overnight money markets functioning properly. Four years ago, increased government borrowing exacerbated a shortfall in bank reserves that occurred when the Federal Reserve cut back on Treasury purchases. Now reserves – the financial “oil” that keeps markets from seizing and interest rates from skyrocketing – and the level at which they are running low are again becoming an issue.
Powell said Wednesday he was satisfied with current reserve levels and said the central bank would slow or halt balance sheet contraction as needed to keep the level “somewhat higher” that the Fed deems “sufficient.” The problem is that it is unclear what the level is.
“I’m going to speak humbly because we don’t know,” said former Federal Reserve President Jeremy Stein, who is currently an economics professor at Harvard University. “It’s very difficult to measure things before you hit a wall, rather than trying to convince people that we know what we’re doing and that we can play pretty close.”
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Central banks are keen to shrink their balance sheets to the smallest possible level without creating chaos or derailing their broader policy objectives. However, this quantitative tightening, or QT, is occurring in a context where banks that would normally fill the slack in critical funding markets are unable to do so due to post-crisis regulatory and other reasons.
In these funding markets, investors, including banks, hedge funds, and money market funds, provide overnight loans collateralized by instruments such as U.S. Treasury bonds. Where these interest rates trade largely depends on supply and demand dynamics, i.e. the balance between the amount of cash in the market and the securities available. Overnight interest rates are generally stable as long as reserves in the system remain abundant.
It is difficult to argue that reserves are insufficient at current levels. There is still less than $800 billion remaining in the Fed’s overnight reverse repo contract facility (RRP). RRPs are a source of excess liquidity where counterparties, such as money market funds, can park cash and assets. You get a 5.3% return. And banks still hold about $3.5 trillion in reserves. This is significantly higher than when the central bank began quantitative tightening in June 2022.
But there are signs that financial institutions are protecting their cash cushions.
“We agree that total liquidity in the system is abundant,” said Mark Cabana, head of U.S. rates strategy at Bank of America Corp. “We are only confident that there is excess in the reverse repo facility. We are less confident about the abundance of reserves in the banking system.”
wall of money
During the COVID-19 pandemic, the Federal Reserve has purchased about $4.6 trillion in Treasury and mortgage-backed securities to keep long-term interest rates low and stimulate the economy. This process created a wall of money that had to be parked somewhere, which led to a swelling of excess liquidity in the form of reserves and balances in RRPs.
To shrink its balance sheet, the central bank has been rolling over some bonds on its balance sheet as they mature since June 2022 rather than replacing them with other assets. The government then “pays” the bonds as they mature by deducting that amount from the cash balance the Treasury has on deposit with the Federal Reserve. In other words, your money essentially disappears. To meet its spending obligations, the Treasury must replenish cash by selling new debt.
The Treasury has increased its reliance on notes for borrowing since June, and its total outstanding debt ratio is now about 21.6%, well above the target range recommended by a group of bond market participants that advise the Treasury. Providing money market funds as an alternative to RRPs had the effect of depleting the facility from the supply of banknotes.
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Meanwhile, a change occurred at the bank. At the start of QT, lenders were comfortable shedding deposits. The institutions had amassed trillions of dollars during the pandemic, so they didn’t mind seeing that many furloughs once the Federal Reserve began raising interest rates in March 2022.
This indifference was shaken by the failure of California’s Silicon Valley Bank and other institutions in March 2023, which led depositors to withdraw trillions of dollars from the banking system as customers realized they could earn more on their cash elsewhere, and to use I was shaken by the switch to alternatives. funds. While the banking system was stabilizing, it came at a cost because institutions had to raise interest rates on certificates of deposit and other products to keep that money afloat.
And unlike the 2017-2019 QT round, when interest rates rose more slowly, banks did not have large unrealized losses in their securities portfolios. As the Fed expanded its balance sheet during QE, commercial banks bought lots of Treasury and agency debt when yields on long-term government debt were well below 3%.
Chart 3
With institutions still carrying these significant losses, they may want to hold more cash as a buffer as attempts to sell securities to increase liquidity will deplete capital and be viewed negatively by the market, according to Bank of America. do.
“That’s the really important difference between why banks today demand liquidity and why they demand more than they thought they would,” said BofA’s Cabana.
That means if reverse repo balances continue to decline, the Fed could halt balance sheet settlements earlier than expected, especially if RRPs are completely empty, which Barclays estimates could come as early as May or June. Prime Minister Powell acknowledged on Wednesday that bank reserves were likely to decline as RRP stabilized.
Myriad Wall Street strategists and Fed policymakers say the central bank is still a long way from reaching a point where it believes reserves are at their most comfortable point and buffers against potential disruption. But they don’t have a definitive answer as to what the point is.
New York Federal Reserve President John Williams met with reporters after a speech last month and said, “It’s still a long way off.” “We want to make sure that sufficient means are actually sufficient. “It is difficult to predict where the reserves are.”
These unknowns, combined with the recent Fed-induced rally across U.S. Treasuries, raise the possibility of further tremors in dollar funding markets, especially as we head towards the end of the year when banks face regulatory balance sheet constraints. According to Barclays, spikes in overnight interest rates could become a recurring problem as market positioning becomes more complex as long positions or bets on low yields require funding from the repo market.
“There will definitely be some who let their guard down,” said Victor Masotti, director of repo trading at broker Clear Street LLC.
