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The Fed has been working QT for some time and but there’s nonetheless considerable liquidity within the monetary system.
Fed’s bond holdings are down $1.3 trillion from their peak (because of QT), but solely half of this supposed tightening has impacted financial institution reserves (aka liquidity) that are down a meager $0.7 trillion.
This ongoing “cash thriller” has caught many off-guard, and it has helped gas a number of bullish narratives: probably the most well-known one being that larger ‘’liquidity’’ has supported inventory markets in 2023.
2024 is shaping to be one other yr the place financial plumbing will matter a fantastic deal.
To know the mechanics behind this cash thriller, let’s begin from QT.
Listed below are 5 easy steps to grasp how Quantitative Tightening works:
Step 1-2: the Fed doesn’t reinvest maturing bonds (1) from its QE portfolio (= performs passive QT) and subsequently destroys reserves (2) – also called “liquidity”;
Step 3-5: the federal government must roll over its funding, however the Fed isn’t rolling over its bond holdings (3).
Banks now must step up and take in extra of the newly issued securities (4-5).
The ensuing steadiness sheet modifications are summarized within the backside tables: the Fed reduces its steadiness sheet by 100 which sees a 1:1 discount in reserves (aka ‘’liquidity’’) as banks should step as much as take in bond issuance.
That is how QT usually works.
But one thing completely different is occurring this time.
Again in 2021, the Fed had a difficulty: charges had been at 0%, and there was an excessive amount of cash within the system.
Cash Market Funds (MMF) had been bidding up T-Payments a lot that yields had been testing destructive ranges (!), and so to stabilize cash market charges the Fed proposed a pleasant different: the Reverse Repo Facility (RRP).
This inspired MMF to park cash on the Fed, they usually did in big dimension: the RRP reached $2.5 trillion.
You possibly can consider this as pent-up ‘’liquidity’’ saved in a nook of our monetary system.
Right here is the factor.
In 2023 MMF has unleashed this pent-up pressure: the RRP utilization has dropped materially, and this wave of supportive ‘’liquidity’’ has been thrown at markets.
And that is more likely to proceed in 2024.
How does this work?
As all the time, let’s verify our stylized steadiness sheets to seek out the solutions:
MMFs drain down their big RRP balances (orange) they usually purchase T-Payments (inexperienced).
The federal government has to roll over debt whereas the Fed does QT (purple), however this time the slack is picked up by cash market funds and never by banks.
The result’s that QT doesn’t drain ‘’liquidity’’ however the RRP takes the hit (blue circle).
Successfully, we’re working a sterilized model of QT:
In different phrases, the Fed is decreasing its steadiness sheet however not draining the ‘‘extra liquidity’’ (financial institution reserves) from the system.
A liquidity conundrum.
So, what occurs subsequent?
The RRP facility is down from $2+ trillion to $600 billion, so this ‘‘sterilization’’ mechanism can work for a bit longer in 2024 however it should in the end come to an finish.
And dwindling liquidity could cause a variety of bother within the largest financial plumbing machine on the earth.
The repo market.
Claiming that the quantity of reserves (‘‘liquidity’’) within the banking system in some way impacts asset costs is outright fallacious: banks don’t use reserves to purchase shares, and that’s why the supposedly direct relationship between modifications in liquidity and inventory market returns doesn’t exist.
Nonetheless, banks do use reserves to have interaction in repo market actions with one another. And that issues.
Because the chart above reveals, the requested premium to lend cash in repo markets towards merely depositing on the Fed is slowly growing – ranges aren’t worrying but, however there appears to be a development in place.
The purple circles within the chart present how unhinged repo markets turned in 2019.
Listed below are the 7 steps to the true financial plumbing threat forward for 2024:
The Fed continues QT however MMF stops immunizing the destructive impact on liquidity;
Financial institution reserves take a severe hit, and banks’ urge for food to have interaction in repo markets declines;
The US Treasury continues to challenge giant quantities of bonds;
The imbalance between collateral (bonds) to soak up and out there liquidity (reserves) grows;
Repo charges steadily improve signaling extra strains within the financial plumbing area;
Leveraged gamers counting on regular repo charges blow up;
Deleveraging happens.
Briefly: the cash trick that made QT seem like a stroll within the park in 2023 would possibly as effectively disappear later in 2024.
It is a very underestimated threat that nearly no person has on their radar.
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Disclaimer: This text was initially revealed on The Macro Compass. Come be a part of this vibrant group of macro traders, asset allocators and hedge funds – take a look at which subscription tier fits you probably the most utilizing this hyperlink.
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