As “higher for longer” starts to bite the economy, we are keeping a close eye on the Fed’s Reverse Repo Program (RRP), which is the best example of excess liquidity. The US Federal Reserve (Fed) must “drain” this liquidity in order to keep market rates in line with its policy rate range.
The Fed has skipped. This outcome was expected—real yields and term premiums have done much of the work for the Fed (although it cautioned that it was too soon to tell if this was having an impact on economic growth and inflation).
Higher long-term interest rates are biting the economy, and the Fed is either being patient or risking a hard landing. Yes, the strength of growth (the gross domestic product [GDP] growth) and the consumer is worrisome, but if the Fed were just focused on the economic data, it might have hiked in September and November.
The previous 525 bp of hikes allow the Fed to pause on further hikes, with the hope that nothing breaks under the current strain of higher funding costs—like an 8% mortgage rate.
Quantitative tightening (QT) has been in the works since June 2022. The size of the Fed’s System Open Market Account (SOMA) peaked in May 2022 at USD 8.4 trn. On average, about USD 18 bn of assets roll off each week. Fed’s SOMA now stands at USD 7.2 trn.
As “higher for longer” starts to bite the economy, we are keeping a close eye on a few metrics: the Fed’s RRP, US T-Bill supply and bank reserves held at the Fed.
The decline in the Fed’s RRP has been dramatic: Since 1 June, RRP balances have dropped by USD 1.1 trn. The new supply of US Treasury Bills (T-Bills) has absorbed this cash. The relative value between T-Bills and RRP has been positive and so money market funds (MMFs) have been moving money out of RRP and into T-Bills.
This has had very little impact on reserves at the Fed. Recall during the previous tightening cycle (2015–2018) there was much discussion on what the lowest level of reserves would be before strains started to emerge.
Reserves got as low as USD 1.5 trn before the repo market cracked and we had a spike in repo funding in September 2019. Currently, reserves held at the Fed are at USD 3.2 trn and really have not changed much over the past year. This makes sense given the excess liquidity in the system.
As discussed in our previous monthly, the Fed’s RRP is the best example of excess liquidity. The Fed must “drain” this liquidity in order to keep market rates in line with its policy rate range. Until RRP balances decline to zero, we should expect quantitative tightening to remain in place and reserves to remain stable.
Meanwhile, government and prime MMFs have been extending their durations. At the beginning of this year, the scars from 2022 were still fresh and durations were around 7–14 days (WAM). As 2023 rolled on, the urge to extend grew as the Fed hinted at a pause in their rate hike cycle. The extension we have seen throughout 2023 has been gradual, with MMF managers still exercising a good deal of caution.
As market participants and the Fed become more confident it has reached a sufficiently restrictive policy rate, average WAMs have moved higher.
Patience will be the hardest part of managing the next few quarters. The Fed has moved policy rates to be sufficiently restrictive. The excess liquidity in the system and the lingering fiscal and monetary stimulus will take some time to work through the economy. How long it takes is everyone’s guess.
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