The Federal Reserve’s (Fed) Quantitative Easing (QE) program is concluding soon and they are looking ahead to balance sheet normalization. While passive run-off of non-reinvested securities will reduce both the asset and liabilities of the Fed’s USD 8.7 trillion dollar balance sheet, it doesn’t mean we should be immediately concerned about lack of liquidity. The Fed controls every aspect of money (cost, supply and distribution) and while there is still plenty of it today, with great power comes great responsibility.

1. Cost of Money
   
   
   1. The Fed’s most powerful tool is the Fed Funds Rate (FFR). It sets the incremental cost of borrowing by financial institutions in the short-term. Despite actual Fed Funds transactions being miniscule, the Fed’s influence over the front-end borrowing costs has never been stronger. Their existing tool kit (Interest on Reserves and Reverse Repo Rates) serves as a powerful corridor to keep the Fed Fund rate elevated, T-Bills positive and reinforces Fed’s credibility.
      
      
   2. While the Fed controls the cost of money via short-dated yields, many investors follow the shape of the nominal yield curve (which extends borrowing costs to longer maturities), which the Fed has less direct influence. Also important is the level and slope of the real yield curve, this reflects the true cost of money and influences financial conditions. Currently, the real yield curve remains at historically steep levels and serves a tailwind to both the economy and markets.
      
      
2. Supply of Money
   
   
   1. The Fed has always used its balance sheet to inject liquidity into the market. However, now that the size of the Fed’s balance sheet is so massive (~38% of nominal GDP today versus ~6% in 2008), the focus has shifted towards how the Fed manages its liabilities. As a quick review: the Fed’s assets primarily consist of the Treasuries and Agency MBS holdings and the Fed’s liabilities primarily consist of reserves and currency, which make up the money supply. The Fed has a tool on the liability side of its balance sheet that is used to drain money supply called the Reverse Repo Facility (RRP), which is very effective. It can change the rate paid on RRP facility to above market rates, which encourages money market funds to increase its usage. Currently, the size of the RRP stands at over ~USD 1.5 trillion and is a function of excess liquidity in the system.
      
      
   2. There is empirical work that suggests the balance sheet size influences the level of real yields to varying degrees across the curve, sometimes referred to as the weight of money. There is also evidence suggesting that not just the level, but also the rate of change in the Fed’s balance sheet as well as forward guidance serve as a critical driver of changes in real yields. In totality, the balance sheet allows the Fed to influence financial conditions, the principal transmission mechanism of policy. A note of caution, while the Fed has full control over the size of their balance sheet, they have less than a full understanding of exactly how and to what extent the balance sheet impacts financial conditions and the real economy compared to the FFR. Fortunately, the Fed is starting from the lowest real yields and the easiest financial conditions on record. So as the supply of money shifts, real yields have far to move before they are restrictive.
      
      
3. Distribution of Money
   
   
   1. The Fed can’t force banks to lend, but they can set a regulatory framework that impacts distribution. This is particularly true for the eight US Banks tagged as Global Systemically Important Banks (GSIBs), which hold nearly 45% of US deposits and in many cases are also primary dealers. When liquidity is ample in the system, regulations such as Supplemental Leverage Ratio (SLR) and GSIB surcharges (and many more) serve as an impediment for the proper distribution of liquidity throughout the system (as we detailed in previous blogs). These regulations impact the intermediation process, influence the seamless flow of liquidity and impact the cost of warehousing (even the most liquid of securities).
      
      
      1. That is why during the market volatility seen in March 2020 primary dealer balance sheets maxed out and Treasury transactions fell. Placing leverage costs on Treasuries and cash doesn’t just impact the financial markets, it impacts traditional banking. As the Payroll Protection Program (PPP) was launched to provide loans to small businesses, the Fed cut SLR requirements on Treasuries and cash, which allowed GSIB banks to grow their balance sheets and distribute these loans, but this was only a temporary reprieve.
         
         
   2. When liquidity gets scarce, the Liquid Coverage ratio (LCR) becomes the binding constraint for large Banks, preventing them from doing additional lending or intermediation activity without additional costs. When those thresholds are crossed, funding markets undergo a tremendous amount of volatility like in September 2019. Fortunately we are in a different regime, there is more than enough liquidity (more than USD 2 Trillion excess liquidity) in the system for GSIBs to meet their LCR requirements even as Quantitative tightening (QT) gets underway.
      
      

With so much control over liquidity, the Fed has the tools to avoid mistakes, provided they remain flexible and calibrate these tools appropriately, which is no easy task. It is unlikely that the regulatory regime will loosen to allow for a better distribution of money through the system, so the Fed will need to lean on its other two tools. We see the likely evolution for the Fed’s approach to removing accommodation in this cycle to be increasingly multi-dimensional, incorporating actively both the cost of the money (FFR) and the supply of money (Balance Sheet).

The Fed has policy space in the form of a massive balance sheet and very negative real yields to fine-tune this new approach, but it will nonetheless be a challenge to balance shrinking the supply of money and raising the cost of money simultaneously. Luckily, the supply of money will still remain abundant even if a more aggressive run-off approach is taken compared to 2017, so investors focus should be on the cost of money, at least initially.

There will undoubtedly be periods of volatility and risk-off as accommodation is removed, but the starting point is so extraordinary that bumps can be managed and ... just remember, the Fed controls everything. But they aren’t immune to missteps first by moving too fast and then by taking too much liquidity away. We will all be watching.

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