(Bloomberg) — As markets staged a huge rally following the Federal Reserve's move to ease monetary policy, part of the financial system had reason to remain nervous.
For participants in the overnight funding markets – a key channel for bank lending and the linchpin for setting interest rates – Wednesday's policy meeting contained a more relevant message from Chairman Jerome Powell than the one that drove stocks higher and the 10-year US yield pushed below 4%: namely that the Fed's balance sheet reduction will continue as planned.
A debate is simmering over whether the Fed is misjudging how much it can shrink its balance sheet – a process known as “quantitative tightening” – without causing dislocation in places like the repo markets, which are part of the basic structure of the financial system. Recent tensions there led to a key interest rate hitting an all-time high, bringing back memories of September 2019, when another overnight interest rate rose five-fold to as high as 10% and the central bank was forced to intervene.
The recent disruptions were indeed on a much smaller scale than four years ago and did not require intervention, but both episodes shed light on the increasingly delicate balance between the Fed, banks and other institutions that helps keep the overnight funding market running orderly functions. Four years ago, increased national debt exacerbated the shortage of bank reserves that arose when the Fed scaled back its bond purchases. Now reserves – the financial “fat” that keeps markets from stalling and interest rates from skyrocketing – and the level at which they become scarce are once again in question.
Powell signaled on Wednesday that he was comfortable with the current level of reserves and said the central bank would slow or stop balance sheet reductions as necessary to ensure they remain “somewhat above” a level the Fed deems “sufficient.” . The problem is that it is unclear what this level is.
“I would be pretty humble because we don’t know,” said former Fed Governor Jeremy Stein, now an economics professor at Harvard University. “Before you hit the wall, it's very hard to assess, rather than trying to reassure people that we know what we're doing and that we can play it pretty accurately.”
The central bank is seeking to reduce its balance sheet to the smallest possible level without causing disruption or jeopardizing its broader policy objectives. But this quantitative tightening (QT) comes at a time when banks that would normally pick up the slack in key funding markets are less able to do so because of post-crisis regulations and other reasons .
Read more: Repo market spikes bring back memories of September 2019 turmoil
In these financing markets, investors – including banks, hedge funds and money market funds – make overnight loans backed by instruments such as U.S. Treasury bonds. Where these interest rates trade depends largely on supply and demand dynamics, that is, the balance between the amount of cash in the market and the securities available. Overnight interest rates remain largely stable as long as reserves in the system are plentiful.
It's hard to argue that reserves are tight at current levels: there's still just under $800 billion stored in the Fed's overnight reverse repo agreement (RRP) facility – a source of excess liquidity, in of counterparties such as money market funds that can park cash earn 5.3% – and banks still have about $3.5 trillion in reserves, well above where they were when the central bank began its latest round of quantitative tightening in June 2022 started.
Nevertheless, there are signs that financial institutions are protecting their liquidity reserves.
“We agree that the overall amount of liquidity in the system is abundant,” said Mark Cabana, head of U.S. interest rate strategy at Bank of America Corp. “We are only confident that there is a surplus 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 Fed bought about $4.6 trillion in Treasury bonds and mortgage-backed securities to keep longer-term interest rates low and stimulate the economy. The process created a wall of money that had to be deposited somewhere, leading to an increase in excess liquidity in the form of reserves and balances at RRP.
Since June 2022, to reduce its balance sheet, the central bank has been rolling over part of the bonds on its balance sheet as they mature, without replacing them with other assets. The government then “pays off” the bond when it matures by deducting the amount from the cash balance that the Treasury deposits with the Fed – effectively making the money disappear. To meet its spending obligations, the Treasury must replenish its cash reserves by selling new debt.
The Treasury has increased its reliance on bills for borrowing since June, and now the percentage of total outstanding debt stands at about 21.6%, well above the target range recommended by a group of bond market participants advising the ministry . By providing MMFs as an alternative to RRP, the provision of bills has the effect of draining the facility.
There is now a change at the banks. At the start of the QT, lenders were willing to draw down deposits. That's because institutions had accumulated trillions of dollars during the pandemic and didn't mind seeing much of it leave when the Fed began raising interest rates in March 2022.
This apparent apathy was shattered in March 2023, when the collapse of California's Silicon Valley Bank and other institutions – and the realization that customers could get more returns on their money elsewhere – led depositors to withdraw trillions from the banking system and turn to alternatives like to switch to the money market. While the banking system has stabilized, this has come at a cost, as institutions have had to raise interest rates on certificates of deposit and other products to hold on to that money.
And unlike during the 2017-2019 QT round, when the pace of rate hikes was slower, banks were not sitting on large unrealized losses in their securities portfolios. As the Fed expanded its balance sheet during quantitative easing, commercial banks purchased many treasuries and government bonds when long-term Treasury yields were well below 3%.
With institutions still struggling with these significant losses, any attempts to sell securities to raise liquidity will deplete capital and be viewed negatively by the market, so they may want to keep more cash on hand as a buffer, according to Bank of America .
“That's a really important distinction between why banks are demanding liquidity today and why they're charging more than they thought,” BofA's Cabana said.
That means if reverse repo balances continue to fall, the Fed could halt its balance sheet deleveraging sooner than expected, particularly if the RRP is completely depleted, which Barclays estimates could be as early as May or June. Powell acknowledged Wednesday that bank reserves would likely fall if the ERP falls.
Read more: Wrightson says Fed QT slowdown starting around June meeting
Countless Wall Street strategists and even Fed policymakers say the central bank is still a long way from reaching the moment when it will determine that reserves have reached their lowest comfortable point – plus a buffer to protect against possible turmoil . But they don't have a definitive answer on this point.
It is “still a long way off,” New York Fed President John Williams said last month after speaking to reporters. “We want to make sure that generous really means abundant. It is difficult to predict where there will be sufficient reserves.”
This unknown, coupled with the recent Fed-driven rally in U.S. Treasury bonds, raises the likelihood of further shocks in dollar funding markets, particularly early in the year when banks face regulatory balance sheet constraints. That's because long positions – or bets on lower yields – need to be funded in the repo market, and so spikes in overnight interest rates could be a recurring problem as market positioning becomes more crowded, according to Barclays.
“There will definitely be people who are unprepared,” said Victor Masotti, director of repo trading at broker Clear Street LLC.
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