The Fed’s Control: Part II
At the start of 2022, we wrote a blog discussing our expectation that the Federal Reserve (Fed) would soon begin its balance sheet rundown, also known as Quantitative Tightening (QT). Our message to the Federal Open Market Committee (FOMC) was that with great power comes great responsibility. While the Fed controls every aspect of money (cost, supply, and distribution), they are not immune to missteps by moving too fast or by taking too much liquidity away.
The Fed has shifted dramatically since the start of the year. Hard to imagine now, but in January 2022, the FOMC was still engaging in Quantitative Easing (QE) at a tapered pace of 60 Bn per month (40 Bn Treasury, 20 Bn Agency MBS). Following the conclusion of their bond buying in March, the total size of the balance sheet peaked in April at ~8.97 Tn. Starting in June, the Fed began QT which reached its maximum rundown pace of 95 Bn per month starting in September. After all that, the size of the balance sheet is only right back to where we started – 8.7 Tn – approximately the same level as it stood in January 2022!
Fed balance sheet has only just started to decline on aggregate
Despite the round trip, much has occurred. Let’s assess what developments have transpired across these three aspects of liquidity and what we expect going forward:
- Cost of Money – major progress
The Fed has aggressively used its most powerful policy tool by hiking rates 375 basis points (bps)—dragging the cost of funding for households and corporations higher with it. Already, the cost of money that influences the real economy has risen by over 400 bps: mortgage rates have increased to over 7% and all-in yields for US investment grade and high yield markets have topped 6% and 9%, respectively. As a result, we have seen the most interest rate sensitive sectors of the economy, particularly housing, slow meaningfully. Real residential investment in Q3 contracted by -26.4% — one of the worst prints outside the pandemic — since 2010. Looking forward, we expect the Fed to further raise the cost of financing—bringing the Fed Funds rate to at least 4.75% by Q1 2023.
In our last blog, we highlighted the real yield curve, which at the time was very steep, as a signal that the Fed had quite a bit more work to do in terms of tightening financial conditions via higher front-end real yields. Since then, the yield curve has shifted from very positively sloped to flat and even to inverted as the Fed brought the policy rate above their estimate of neutral (2.5%) at breakneck speed. Real yields are positive across the curve with the 2-year real yield near 2%—a level only briefly seen during the end of the last tightening cycle.
The Fed has hiked rates aggressively this year
The real yield curve has flattened as the front-end has risen and financial conditions have tightened
- Supply of Money – some progress
While the Fed’s balance sheet is just back to the size it stood in January 2022 at 8.7 Tn, bank reserves (a liability for the Fed and an asset for commercial banks) have declined from 4 Tn to 3 Tn.
So, how can it be that bank reserves declined by ~1 Tn and the total size of the balance sheet is unchanged compared to the start of the year? The explanation is a bit technical but, put simply, while total liabilities were unchanged, there was a shift in components of the Fed’s liabilities. Bank reserves moved into the overnight reverse repo facility (ONRRP) as commercial banks shed deposits and investors took advantage of higher money market yields. Money market funds have been putting an increasing share of their cash into the ONRRP due to a scarcity of other short-term investable assets (mainly bills) as well as a desire to keep their weighted average maturity (WAM) as short as possible to protect against rising rates.
Looking forward, the Fed is set to continue its passive rundown of 95 Bn per month, which will shrink both reserves and the overall size of the balance sheet. In terms of the composition of liabilities, once money markets have visibility on the path of the Fed Funds rate, they should start to move out of the overnight reverse repo facility to marginally extend their duration; however, the extent of this is limited by continually low bill supply and rich valuations.
The next logical question is: how much can the Fed ultimately shrink the balance sheet? Using the 2018 experience, where the Fed also embarked on QT as a road map, the banking system ultimately ended up needing more reserves than what the Fed and the market originally estimated. This time we would encourage conservative estimates again while recognizing that there are several uncertainties including 1) the non-linear impacts of removing reserves when approaching frictional levels 2) the debate over what matters more: the stock vs a flow effect, particularly for financial conditions 3) the interaction between balance sheet and rate hikes.
In the last normalization cycle, the Fed used the Senior Financial Officer survey (a survey of domestic and foreign banks) to understand how banks are managing their reserve balances and the minimum level they could operate with. The survey released back in September 2018 showed that the minimum level was ~1 Tn, but the Fed was only able to shrink to about 1.4 Tn in excess reserves. Applying similar analysis for today, a conservative minimum reserve level would be around 2-2.5 Tn, which would imply an additional 6-12 months of QT (depending on the interplay of bill supply and Money Market Fund’s use of the ONRRP)
- Distribution of Money – no progress
While the Fed can’t directly impact this, they can and do set a regulatory framework that influences the distribution of money within the financial system. 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. These regulations impact the intermediation process, influence the seamless flow of liquidity, and impact the cost of warehousing (even the most liquid of securities).
Particularly during periods of high market volatility, like the Gilt market crisis in October 2022, investor conversations tend to build around the potential for adjustments to these rules—adjustments that would free up balance sheet capacity for dealers to better promote liquidity. Despite the conversations, very little has actually been done. We see limited forward momentum to improve the distribution of reserves and to improve dealer intermediation through changes to the calculations used in these regulations. The topic continues to be a big wild card for financial market participants, and it is where we remain most cautious both in terms of financial stability and credit markets.
After nearly a year since our first update, the Fed’s balance sheet journey has only just begun. They have successfully and materially increased the cost of money but are only just beginning to reduce the supply and will continue to struggle with distribution. Beware of liquidity risks into year-end but be even more cautious as 2023 progresses and the cost of money continues to rise, the supply of money continues to detract, and the distribution of money remains impaired. The latter of which could have unintended, unexpected, and non-linear impacts on financial conditions.