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- My February expectation that QT would end in 2023 H2 did not happen due to:
- Slower bank loan growth.
- Increased Fed lending to banks after the spring bankruptcies.
- Tight money market liquidity that reduced use of the Fed RRP facility by MMFs.
- I do not expect these events to repeat in 2024; in particular, I expect looser money market liquidity and a slower reduction in the Fed RRP usage.
- Based on these assumptions, I expect QT to continue through 2014.
- Continued QT and a likely lack of fiscal consolidation to pressure bond yields.
Bank Assets Drive Reserves Demand
In February 2023, I expected QT to end in 2023 H2. In this note, I review why I was wrong and argue that QT is likely to last through 2024.
My QT framework consists of two elements:
- The Fed’s ample reserves framework. The Fed wants to leave enough reserves in the system so small changes in the quantity of reserves do not impact money market rates (see Dallas Fed President Logan’s recent speech). At the same time, the Fed would rather have no more reserves than ample because of the negative carry cost of its portfolio and associated losses (Chart 1).
- Bank demand for reserves is driven by their balance sheets. In Fed surveys, banks cite liquidity needs as key drivers of their reserve holdings. Liquidity needs are driven by banks’ assets, mainly their loan books, and by the regulatory costs of holding reserves.
During QT1 (October 2017-September 2019), the spread between the FFR and interest on reserves (IOR) started to tighten, a sign that reserves were no longer ample, when reserves fell below 25% of banks’ loan books (Chart 2). In February, when I predicted that QT would end in H2, reserves represented about 26% of bank loans and seemed to be headed down. Three events, however, falsified my prediction.
Tighter Liquidity Reduced Fed RRP Usage
First, the March banking crisis led the Fed to increase lending by about $350bn, which increased its balance sheet size and therefore reserves.
Second, bank lending flattened in H1 2023 (Chart 3). Lending growth resumed in Q3 but more slowly than in 2022, which weakened the demand for reserves.
Third, the Treasury embarked on a massive TBill issuance program, which funded a buildup in the TGA (Chart 4). That is, the proceeds of the TBill issuance were not recycled through deficit funding (that transfers liquidity from the TGA to the banking system), but sterilized through an increase in the TGA.
This absorbed money market liquidity and saw the spread of TBills and market RP rates over the Fed RRP increase. As a result, MMFs moved their liquidity into TBills and market RRP (Chart 5).
This kept reserves constant but reduced MMF use of the Fed RRP. In fact, reserves have been increasing since end-Q2, largely due to a decline in the Fed foreign RRP (Chart 6 and Table 1).
QT to Last Through 2024
I assume none of these three events will repeat in 2024. That is, I assume an increase in bank loans of about $250bn for the whole of 2024, against about $100bn during July-November 2023. On that basis, bank loans would rise to about $12.5tn and reserves would no longer be ample once they fell through about $3.1tn.
I also assume no new crisis and associated Fed lending. That is, the reduction in Fed assets will be driven by the reduction in the securities portfolio, at a pace of about $80bn/month, in line with 2023.
Finally, I assume money market liquidity will not be as tight as in 2023 due to the Treasury reducing the share of TBills in total issuance and to no more TGA buildup. As a result, I expect that only about 2/3 of the decrease in the securities portfolio will impact the RRP rather than reserves. As shown on Table 1, based on these assumptions, reserves would fall by about $350bn relative to currently $3.5tn.
Reserves would therefore remain ample through 2024 and QT would continue.
My view that QT will last through 2024 and end after reserves fall through $3.1tn compares with the October 2023 primary dealers survey showing median expectations for end-December 2024 reserves at $3tn. In addition, the median expectation of primary dealers for the end of QT is Q3 2024.
Against my expectations of continued QT through 2024, I also do not expect fiscal consolidation in 2024. It is an election year and, if anything, the administration is likely to bolster spending. In addition, the window of opportunity for fiscal brinkmanship on the part of House Republicans has likely closed. Closing the government after the election season starts in January would threaten their electoral chances.
Against this backdrop, continued QT is likely to pressure yields as the Treasury will have to find new buyers to replace the Fed.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)