Will QT end early?

Good morning. US labour market data came in hot again yesterday, in the form of ADP payrolls, and this time the stock market took notice. Meanwhile, depositors in Silvergate, a crypto-focused bank, withdrew $8.1bn in the fourth quarter. And you know what? Silvergate had the money! The bank’s shares may be down 94 per cent but (for now, at least) it looks like crypto’s adult in the room. Email me:

Will the Fed chicken out on QT?

The hot potato theory of asset values works as follows: People and institutions target a certain mix of risk assets and cash in their portfolios. When loads of cash get pushed into the system, everyone says, “I have too much cash in my portfolio, I better buy some risk assets to get the mix right.” But when someone buys stocks or bonds, the cash they got rid of just goes to someone else. Now that person has too much cash and goes shopping for risk assets. Round and round we go, bidding up the price of everything, until either liquidity gets pulled out of the system or the aggregate desire for cash relative to risk assets increases.

Unhedged buys this theory, more or less, which makes us think that quantitative tightening — or if you prefer, “Federal Reserve balance sheet runoff” — is an important headwind for asset prices. The Fed balance sheet is being allowed to shrink at about $95bn a month, meaning someone else owns that much more in Treasuries, and holds that much less cash. The potato gets passed along a bit more slowly.

Line chart of Federal reserve balance sheet, $bn showing Rise quickly, fall slowly

As much as the Fed wants to shrink its balance sheet, however, it also wants to make sure there is enough cash in the system, and that the cash is in the right places. It wants the financial plumbing to keep working, rather than clogging like it did in, say, September of 2019 or March of 2020. And the Fed certainly looked on in horror as the UK gilt market broke down completely last October.

Joseph Wang, on his indispensable Fed Guy blog, pointed out last month that QT is not going perfectly from the Fed’s point of view. “An ideal QT would drain liquidity in the overall financial system while keeping liquidity in the banking sector above a minimum threshold,” he points out. But where will the cash absorbed by QT come from, if not from the banking system (that is, from bank reserves held at the Fed)? From the Fed’s reverse-repo programme. The RRP is designed to support Fed interest rate policy by absorbing excess cash that would otherwise drive short rates below the central bank’s target rate. Money market funds deposit cash with the Fed, receiving Treasury securities as collateral, and collect interest. But the RRP, though it mostly stopped growing back in June, has not shrunk:

Line chart of Federal Reserve reverse repurchase agreements, $bn showing Stubbornly high

What has happened instead is money has come out of bank reserves, where the Fed wants it to stay:

Line chart of Bank reserves deposited with the Fed, $bn showing It would be good if this line stopped falling soon

Wang thinks that instead of money market funds buying up Treasury securities, and therefore shrinking the RRP, households have done so instead (for “households” here you can read “people who manage people’s savings and investments”). This is not terribly surprising, given that households can buy now-higher-yielding Treasury securities directly, rather than paying a money-market fund a fee to do it for them, and that the RRP likely pays the money market funds more than the securities would.

The Fed appears to think that the banking system needs reserves of something over $2tn in order to ensure smooth functioning. We are heading down towards that threshold at a good clip. To Wang, this suggests that it is “unlikely that QT can run its expected 2+ year course”.

Others, looking at the same dynamics, take a different view. Liquidity maven Michael Howell of Crossborder Capital sees other factors that may push liquidity back into the banking system, as he argued in a piece in the Financial Times last week. The RRP is likely to shrink “because there are hints that the Treasury will issue more bills . . . relative to bonds which have longer terms”, which money market funds will buy. In addition, the Treasury may run down its own bank account, pushing cash into the economy, as it rushes to pay the government’s bills ahead of a possible congressional battle over the debt ceiling this year. Finally, higher interest rates mean the Fed pays more interest into the banking system, perhaps $200bn worth this year. Howell calls all this “stealth QE”.

He also pointed out to me that there are global forces pushing liquidity into the financial system. A weaker dollar and lower oil prices free up cash globally; the former makes dollar debts easier to bear, while the latter means less cash is tied up funding energy inventories and transactions. The central bank of China is also showing signs of adding liquidity as it tries to prop up an economy hit hard by Covid-19.

In sum, Howell thinks that total global liquidity has hit a bottom and is likely to rise from here. If he’s right, that is good news for asset prices. But he cautions that there is usually a lag, often of many months, between liquidity bottoming and asset prices recovering. Investors are not in the clear yet — and much depends not only on the Fed’s choices, but also on the dollar, oil prices and Chinese policy. Unhedged will keep you posted.

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