Article

Attention turns to quantitative tightening

How will the Federal Reserve’s quantitative tightening programme affect financial markets in the near and longer-term future?

| 6 min read

The direction of interest rates has absorbed market attention for much of the past two years. Financial markets have been driven by even the subtlest variations in central bank rate expectations. However, increasingly, there may be a new preoccupation, based around liquidity and the Federal Reserve’s quantitative tightening programme.

Repo market highlights strain on bank reserves

In the wake of the financial crisis, the Federal Reserve started to buy government bonds and mortgage backed securities, leaving it with a peak balance sheet of $8.5 trillion. It is now looking to shrink this balance sheet via quantitative tightening, or QT. As part of this programme $60bn of US treasuries and $40bn of mortgage backed securities (MBS) are allowed to mature each month.

This has repercussions elsewhere in the financial system, particularly for bank reserves. During quantitative easing (QE), banks and financial institutions had ample amounts of liquidity. Much of this cash was held as bank reserves (currently at levels of c.$3.5 trillion) or c.15% of GDP. However, the process of QT can put a strain on bank reserves. They can decline as commercial banks buy the treasuries not absorbed by the Federal Reserve.

These problems can be felt in ‘repo market’. A repurchase agreement (repo) is used by commercial banks who need to borrow cash to cover short term obligations. They sell US treasuries to a counterparty and buy them back at a higher price. When the Fed started QT in 2019, bank reserves fell to c.7% of GDP, prompting a huge demand from banks to use the repo facility, which in turn sent repo rates skyrocketing, sparking major liquidity and financial stability concerns.

There were concerns this could happen again. QT, combined with the vast issuance of new debt to support the US government’s spending needs, would see bank reserves decline. Market concerns were heightened by the collapse of Silicon Valley Bank in March 2023 and, more recently, problems at New York Community Bank.

Nevertheless, in spite of the large amount of QT, bank reserves have remained robust – or ‘ample’, to use central bank speak (a word that will likely be quoted a lot more in the coming months – the new ‘pivot’). However, it appears that much of this strength had been supported by the supply of cash held at the Fed’s reverse repo facility (RRP).

What is a reverse repo transaction?

Financial institutions were so flush with cash following the QE episode of 2020 and 2021, they ended up parking excess cash balances with the Federal Reserve, for which they received an exchange rate – a reverse repo transaction.

It proved a popular option for banks. By the end of 2022, the US Fed’s reverse repo facility had over $2.6 trillion of excess cash parked there. At the same time, banks had ample reserves balances of over $3.5 trillion.

Daily RRP demand remained robust until June 2023. After that point, balances shrunk rapidly, falling below $600bn. The culprit? Funds shifted out of RRPs in order to absorb the flood of treasury bill issuance that followed the June 2023 suspension of the debt ceiling. This creates a problem.

US debt is vast, and requires significant issuance. It begs the question of who will buy the large amount of US treasuries when the RRP balance is depleted?

Treasury issuance

There is a concern that if QT continues at its current pace, this supply may be bought by commercial banks. They would see their cash reserves decline as a result. This could exacerbate concerns over market liquidity.

Prolonging QT is likely to see private market participants step in to buy US treasury issuance, who would demand a large premium in yields given the amount of supply. The threat of a significant rise in yields – with its knock-on effects for economic growth - is likely to make markets very sensitive to comments from the Federal Reserve around the tapering of the QT programme.

There is now a concern that when the reverse repo facility hits zero, the US government will still have a huge deficit to fund. It will have to carry on issuing debt, with expected increases in auction sizes for the next three months. Foreign investors have reduced their participation in treasury auctions over the past couple of years as their domestic bond markets have become more attractive.

Implications for the treasury market

The Federal Reserve is alert to the problem and has plenty of time to act. It is likely to be 12-18 months before reserves fall to levels that may cause similar issues to those seen in 2019. Liquidity has already been raised as a key issue in FOMC discussions. Oxford Economics says the Fed is likely to act by tapering its QT programme should reserves fall below 12% of commercial bank assets.

Banks want to keep reserves relatively high. The regional banking turmoil and renewed liquidity concerns has driven banks to hold higher reserves. Many are also sitting on unrealised losses on longer-dated treasuries. They don’t want to sell these assets in the short-term, leading them to bulk up on cash via their reserves.

If the Federal Reserve starts tapering in the next few months, it could be supportive for US treasury yields. Less QT reduces the treasury supply available to be bought by the commercial banks. Treasury issuance might also shift back towards more normal, longer-dated issuance, having been significantly skewed towards short-dated T-bills and treasury notes. If the market were to see a lot of longer-dated issuance, it would need to be absorbed by ‘yield sensitive’ private market participants.

The risks are well-understood and being managed by the Federal Reserve. However, treasury market yields – and therefore broader stock and bond markets – are likely to be sensitive to Federal Reserve commentary around its tapering programme. Views are mixed: Bank of America and Barclays have forecast that tapering could begin as early as April, however Deutsche Bank expects the Fed to begin tapering in June. If the Fed starts tapering in June, coupled with a rate cut, it could be positive for risk assets. However, if it delays, and bank reserves start to decline, risk assets could struggle.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

How will financial advice evolve in the coming years?

Get your copy of AKG's latest research paper on the future of advice.

See more

More insights

Article
Hot inflation hits rate-cut hopes
By Garry White
Chief Investment Commentator
12 Apr 2024 | 11 min read
Article
US navigates major geopolitical tensions
By Charles Stanley
11 Apr 2024 | 9 min read
Article
Fed speak upsets markets
By Garry White
Chief Investment Commentator
05 Apr 2024 | 7 min read
Article
The future of Nato
By Charles Stanley
04 Apr 2024 | 10 min read