The Fed’s QT implementation should begin after the May FOMC meeting (download full commentary for size and timing of implementation.) We would expect that, over time, excess liquidity in the money markets will be drained and we could see upward pressure on some short term money market rates.
When we look at the events of the last QT (2018-2019), the Fed did not anticipate how quickly the reduction in reserves and subsequent increased holding of US Treasuries (UST) would cause a crisis in the short term funding markets. In September 2019 (20 months after the beginning of QT), Treasury repo funding levels (dealers needed to borrow cash to fund UST) spiked to 10% and overnight bi-party and tri-party reverse repo levels rose to over 5%. The relatively “new” SOFR rate showed extraordinary volatility and caused considerable consternation over the viability of this new LIBOR replacement rate. Looking back we see the funding pressures emerging at each month end (Jan-Aug 2019) leading up to the fateful day in September.
Why did this happen? Simply put primary dealers did not have capacity to provide funding to all of the UST that were in the market. As the Fed stopped their reinvestment, it was left to the primary dealers to make up for the decline in demand. They, in turn, needed funding on this additional supply through the repo market. Excess reserves had only declined by $700bn to $1.5tn. At the time, it was thought that the Fed would like to see excess reserves drop to closer to $1tn, but the funding crisis of September halted QT, and the Fed began to reinvest their maturing UST and MBS.
There are a few things that are different this time around and thus we don’t anticipate the funding stress we saw in 2019 to occur in 2022 or even 2023. Why? First: levels of excess liquidity are significantly higher in today’s market. In September 2017 QT was announced. In Q4 2017 the Fed’s RRP averaged $96bn in daily utilization. In Q1 2022 it averaged $1.6tn. In order for the participation in this RRP program to decline there needs to be a more favorable alternative – i.e., the offer on dealer repo needs to trade at or above the Fed’s RRP rate (currently 0.30%) and/or 1-month T-bill yields need to be at or above this rate. Both were the case starting in H1 2018. In 2018 1-month bill yields averaged 16 bps above the Fed’s RRP offered rate. In H1 2019 they averaged 15 bps above the RRP. Over the past 30 days the 1-month bill has yielded 9bps below the RRP offered rate.
Second and most important: the Fed established two financing programs that were made permanent in July 2021. First: The Standing Repo Facility (SRF) will allow primary dealers to fund UST and MBS with a program limit of $500bn. Second: the foreign and international monetary authorities (FIMA) repo facility will be limited to $60bn per counterparty of UST held at the New York Fed. This second program should alleviate pressures on the FX market in times of stress (think March 2020). Both of these programs will have a similar but opposite effect of the Fed RRP’s floor on short term rates. They will provide a ceiling on short term rates. The current SFR and FIMA rates are the top of the Fed’s target rate range. We expect that to remain the case.
So then how long before we start to see upward pressure on short term yields, similar to what was seen in 2018 & 2019? Sadly a long time. The Fed does not plan to allow their T-Bill holdings to roll off as they mature but rather use the holdings as a top up to reach the $60bn QT ceiling for UST. Therefore it is expected that only ~$40bn of T-Bills will mature off the Fed’s balance sheet this year, and we might not see all T-Bills roll off the balance sheet until 2025. The Treasury is currently paying down ~$350bn of T-Bills due to incoming tax receipts (typical in Q2). In the second half of the year some estimate the US Treasury will need to increase T-Bill issuance by ~$360bn to cover the paydowns in T-Bill issuance seen in H1 and the additional cash the US Treasury will need due to the Fed’s QT. This supply will most likely not satisfy demands by money market funds and other short term investors; thus, we should continue to see excess balances at the Fed’s RRP.
As the calendar turns to 2023 there are many variables that will impact market levels: reserve balances/bank deposits, MMF balances and T-Bill supply. It is possible we see MMF balances continue to grow as the market rate of return they offer will out-yield bank deposits. Banks should allow this to happen as most are “over deposited”. If the MMF bid holds strong then we may continue to see high balances in the RRP. This will be the “anchor” rate in the money markets. It would be unlikely to see any funding pressure, similar to September 2019, before 2024. I type that with caution as we know things can often change fast and for any number of reasons.
Source: State Street Global Advisors
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