Chief China Strategist
Summary: This article delves into the complexities surrounding the Federal Reserve's approach to Quantitative Tightening (QT). Examining Fed Chair Powell's recent statements, it emphasizes the importance of reverse repo levels and reserve balances in determining the pace of QT. The article explores the dynamics of the ample reserve regime and highlights the potential risks associated with declining reserve balances. Key indicators, such as the spread between SOFR and the Interest on Reserve Balances, are scrutinized for signs of liquidity stress. As the FOMC discussions evolve, the article suggests closely monitoring various factors to decipher the Federal Reserve's balancing act and anticipate market implications.
Key Points:
Introduction
The Federal Reserve's recent pronouncements on the future trajectory of Quantitative Tightening (QT) have injected a new dimension of complexity into the financial landscape. The post-FOMC press conference on December 13, 2024, featuring Federal Reserve Chair Powell's insights, initially suggested a status quo in the pace of QT. However, the subsequent release of FOMC minutes unveiled a nuanced tapestry of perspectives within the Committee. This article undertakes an exploration of the technical intricacies that may guide the Federal Reserve's decision-making process regarding the reduction of its securities holdings and therefore its balance sheet, a phenomenon colloquially known as quantitative tightening.
Understanding Powell's Perspective and the Ample Reserve Regime
Fed Chair Powell's declaration on December 13 that the Federal Reserve is presently "not talking about altering the pace of Quantitative Tightening (QT) right now" provided a glimpse into the central bank's current stance. Powell elucidated that the reverse repo facility's (RRP) take-up had been rapidly decreasing, resulting in a surge in reserves despite the shrinking size of the Fed’s securities portfolio and its balance sheet. He outlined the Fed's plan to continue the balance sheet runoff when the RRP levels out, allowing reserves to begin their decline.
Powell emphasized the Fed's intention to diminish its securities holdings as long as reserve balances, i.e., deposits held by banks at the 12 Federal Reserve banks, are "somewhat above the level judged to be consistent with ample reserves." He went on to say that we are "not at those levels… with reserves close to [$]3.5 trillion."
After the Global Financial Crisis in 2008, the Fed transitioned from a scarce reverse regime to an ample reserve regime. In a scarce reserve regime, banks kept only minimal reserves at the Fed to fulfill regulatory requirements and facilitate daily payments. Neither required reserves nor excess reserves earned interest, so banks aimed to lend out as much as reasonable given their anticipated payment obligations during the day. The reserves held by the banking sector as a whole at the Fed were less than $50 billion. Under the scarce reserve regime, overnight interest rates were sensitive to the amount of excess reserves available for banks to lend out in the unsecured Fed Fund market and the secured repo markets. The Fed conducted open market operations, such as repos and reverse repos, to affect the amount of excess reserves in the system and to control the policy overnight Fed Fund rate.
Under the ample reserve regime currently we are in, overnight interest rates are no longer reacting to the changes in reserve balances as the latter is ample. Changes in reserve balances, except in some cases where the supply of reserves falls dramatically within a short period or the demand for reserves soars due to external shocks, will not move the overnight policy Fed Fund Rate. Therefore, the Fed’s open market operations lost their efficacy in controlling the policy Fed Fund Rate.
As a result, the Fed has since adopted two administered rates to maintain the overnight Fed Fund targeted range that it announces. The first is the Interest on Reserve Balances (IOBR), an administered rate that the Fed pays for all reserve balances, as much as the banks want to place at the Fed. Since 2020, the Fed has even completely abandoned the minimum requirement of reserves so there is no longer distinguishment between required and excess reserves but only reserve balances. The IOBR is currently 5.4%, which is 10 bps below the upper bound of the targeted range of the overnight Fed Fund. The second administered rate is the fixed award rate that the Fed pays for reverse repo transactions (RRP rate) with domestic non-bank institutions, including Federal agencies and money market funds, for unlimited amounts. The RRP rate currently is 5.3%, which is 5 bps above the lower bound of the targeted Fed Fund Rate.
A full discussion of the ample reserve regime would require much more space than this short article. In brief, Powell is conveying that the Fed will continue to operate under the post-2008 ample reserve regime and will cease quantitative tightening before the reserve balance falls to a level that may no longer be considered ample.
When Will Reserves Be at Risk of Not Being “Ample”?
In the December FOMC minutes subsequently released on January 3, 2024, it was revealed that " several participants remarked that the Committee’s balance sheet plans indicated that it would slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged consistent with ample reserves. These participants suggested that it would be appropriate for the Committee to begin to discuss the technical factors that would guide a decision to slow the pace of runoff well before such a decision was reached in order to provide appropriate advance notice to the public.”
In Fedspeak, the term “several participants” signifies a perspective distinct from the dominant view, which is typically characterized by terms such as "all," "all but one," "almost all," "generally," "most," "majority," "many," or "some," before descending to the quantitative term “several,” as illustrated in this explanatory note from the Fed. However, it is now the time for investors to pay attention to the technical factors that may determine the adequacy of reserves.
Two pivotal factors, according to Powell, influence the decision-making process. Firstly, the amount of reverse repos on the Fed's balance sheet serves as an indicator. As this balance approaches zero, it ceases to act as a buffer, leading to a decline in bank reserves as the Fed continues to run off its securities holdings. Secondly, Powell highlighted the critical level of reserve balances, signaling a need to slow down or halt the reduction when reserves fall to a level slightly above what is considered ample.
Illustrating the Dynamics
As of January 3, 2024, the size of the Fed’s balance sheet was $7.73 trillion. It consisted of two major categories on the liabilities side: $3.46 trillion in bank reserve balances with the 12 Federal Reserve banks, and $4.27 trillion in other factors, including $0.72 trillion in reverse repos (excluding foreign official and international accounts) and $0.74 trillion in Treasury General Account (TGA) balances at the Fed.
Figure 1 below illustrates that as the Fed trimmed its balance sheet, bank reserves increased even when the Treasury General Account rose. The rundown of securities holdings reduced the size of the Fed’s balance sheet, causing liabilities to shrink by the same amount. Since money market funds invested less in reverse repos with the Fed as they took up more Treasury bills, their funds were diverted from sitting on the Fed’s balance sheet to the Treasury General Account when they bought Treasury bills from the Treasury in actions or to bank reserve balances if they bought Treasury bills in the secondary markets. The increasing supply of T-bills from the Treasury and anticipation of the Fed cutting rates in 2024 contributed to this shift. Additionally, when the Treasury spent its money, the fund flowed from the Treasury General Account at the Fed to banks and ended up as reserve balances at the Fed. Therefore, as long as there were still large reverse repo balances and mutual funds were buying Treasury bills, the runoff of the Fed’s balance sheet did not affect the reserve balance. For a more detailed illustration of the mechanism and accounting, readers can refer to our previous article.
Nonetheless, once the reverse repos are exhausted or money market funds are less willing to buy Treasury bills, the reserve balance will start to decline. How far the reserve balance drops will be considered at risk of not being ample? In the December post-FOMC press conference, Powell stated that $3.5 trillion is more than ample. In other words, he is willing to let the reserve repos run dry and the reserve balances run off somewhat from the current $3.5 trillion. However, Dallas Fed President Lorie Logan, on January 6, 2024, suggested that the Fed "should slow the pace of runoff as ON RRP balances approach a low level." In other words, unlike Powell, Logan leans toward maintaining a reserve level closer to $3.5 trillion and is not inclined to see a decline in it.
The Spread between SOFR and the Interest Rate on Reserve Balances as a Stress Indicator
Is it $3.5 trillion or lower? How much lower? One potential indicator of liquidity stress is the spread between the market overnight repo rate (secured overnight financing rate or SOFR) and the Fed-administered rate of interest on reserve balances (IORB). When reserves fall to a level where changes in reserves start impacting short-term interest rates, the Fed will consider that the level of reserves is no longer ample.
The Fed underwent QT once before between October 2017 and July 2019. During this period, the Fed’s balance sheet shrank by 16%, from $4.5 trillion to $3.8 trillion, and the reserve balance fell by 35%, from $2.3 trillion to $1.5 trillion. Over the year-end from December 31, 2018, to January 2, 2019, the spread between SOFR and the IORB spiked to 275 bps due to stress in Treasury security dealers’ balance sheets amid year-end funding pressure, accompanied by additional auctions of Treasury securities (Figure 2).
What does it indicate about liquidity stress in the banking system? It may be because, under normal circumstances, SOFR should not be significantly higher than the IORB. If SOFR is higher, banks will withdraw money from their accounts at the Fed and lend it in the overnight repo markets, which are secured by Treasuries as collaterals. Since 2020, there is no minimal requirement on reserves in the U.S., so how much reserve to maintain at the Fed is entirely determined by banks. Another spike in the spread, a barometer of short-term money market liquidity, occurred in mid-September 2019 as the SOFR and IORB spread blew out to close at 390 bps on September 17, 2019, as reserves fell sharply due to a settlement of $54 billion new Treasury issuance and corporate tax payments due on September 16, both having the effect of moving funds from reserves to the Treasury General Account. The reserves balance dropped by $120 billion over two days. A third spike happened in mid-March 2020 when the Covid-19 crisis intensified, and the spread between SOFR and the IORB rate climbed to 76 bps on March 16, 2020. However, as reserves were stable through January and February 2020 and even started climbing at the beginning of March, unlike in the previous two episodes in December 2018 and September 2019 due to a sudden fall in the supply of reserves, the spike in March 2020 was apparently due to a sudden drastic increase in the demand for reserves. This surge in demand for reserves came as the Treasury securities markets melted down as investors sold risk assets for cash. The 10-year Treasury note yields soared from 0.54% on March 9 to 1.19% on March 18, 2020, until the Fed intervened and bought a large amount of Treasury securities.
Since these three spikes in the spread of SOFR versus the IORB rate, economists at the Fed and academia have published numerous research papers (e.g. Copeland, Duffie & Yang, 2021; Afonso et al, 2023), highlighting the importance of monitoring this spread as one of the signals of the sufficiency of the supply of reserves to meet the fluctuating demand for reserves.
At the run rate of $95 billion a month, and assuming the Treasury will keep the TGA balance at around the current level of $740 billion, it may take approximately seven to eight months before the reserve repo balances deplete to near zero in July or August this year, and further QT will bring down the reserves.
Given the incident at the end of 2018 when reserves fell to as low as $1.5 trillion, it is reasonable to expect that the Fed will not want reserves to fall towards that level. Where to stop between $3.5 trillion and $1.5 trillion is not known. Despite reserves typically being below $50 billion before the Fed moved from a scarce reserve system to an ample reserve system after the Great Financial Crisis in 2008, research conducted by economists at the Federal Reserve System tends to suggest that the meaning of “ample” requires reserves close to the current level to manage the risks of a sudden increase in the demand for reserves, with a notable exception of Haubrich (2023) which come to much smaller estimates.
An additional stress indicator is the recent surge in the Fed's Bank Term Funding Program (BTFP). The BTFP recently surged to $141.2 billion last Wednesday, Jan 3 (Figure 3), the highest point since its commencement and 16% higher than a month ago. The Fed launched the BTFP on March 12, 2023, to lend to banks that come to the Fed with collaterals, mainly Treasuries, agency securities, and agency mortgage-backed securities. The crucial feature of the BTFP is that the Fed will value the collaterals offered by the borrowing banks at par. The BTFP is supposed to accept requests for term loans up to 1-year in tenor until at least March 11, 2024, which is approaching. Will the take-up of loans under the BTFP accelerate in the coming three months, and will that reflect some stress in some corners of the banking sector and be part of the consideration of the Fed in determining whether to slow or end the QT, remains to be seen.
Conclusion: Deciphering Conditions for the End of QT
In conclusion, while the FOMC has not arrived at a consensus on the timing or preconditions for slowing down the balance sheet runoff, the discussion has gained momentum. Market speculations suggest potential actions as early as April, this summer, or later in the year. The implications of these decisions are monumental, impacting perceptions of liquidity and influencing investors' risk appetite.
Navigating the uncertainty requires a vigilant eye on various indicators. In addition to decoding Fedspeak, closely monitoring reverse repo balances, reserve levels, the SOFR-IORB spread, and the uptake of the Bank Term Funding Program will provide valuable insights into the Fed's considerations and potential future actions. As the market awaits further guidance, understanding the technical intricacies becomes paramount in deciphering the Federal Reserve's balancing act in the evolving economic landscape. When the conditions for ending QT are ripe, the Treasury market may find support and causing yields to fall while the dollar faces downward pressure.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
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