As bank reserves decline to levels that may restrict bank activity, markets will likely signal the Fed may need to change course.
Jordan Jackson
Global Market Strategist
Jordan Jackson:
Hi, my name is Jordan Jackson, and welcome to On the Minds of Investors. Today's post asked the question, "What should I know about quantitative tightening?" In January, we wrote about our expectations for quantitative tightening, or QT, and the impact it could have on markets. Now that the Federal Reserve has ironed out the details of QT and begun the process, below we address the most pressing questions we're getting from clients. First, what are the characteristics of QT? The committee will begin to reduce the re-investments of principal payments in US treasuries and mortgage-backed securities in June 2022. Maturing US treasury securities will be capped initially at 30 billion per month from June to August, then increase to 60 billion per month in September. The maturity cap on mortgage-backed securities will initially be set at 17.5 billion per month and will similarly double to 35 billion per month in September. Maturing amounts above these caps will be reinvested. Under these assumptions, 650 billion mortgage-backed securities and 1.5 trillion in US treasury securities will mature through December 2024, resulting in a $2.2 trillion decline in the Fed's balance sheet. This would shrink the balance sheet from 8.9 trillion to 6.6 trillion by the end of 2024, well above the pre-pandemic peak of four and a half trillion.
Second, how does the withdrawal of liquidity work? QT is when the fed receives principal repayments from its security holdings, and rather than use those proceeds to purchase new securities, it extinguishes it and reduces the amount of reserves in the system. The removal of liquidity will manifest itself in variable ways on the liability side of the balance sheet via the treasury general account, reverse repo facility, and predominantly in bank reserves. Bank reserves, fed balance sheets has assets and liabilities. If they reduce their assets, then liabilities must balance and similarly decline. A recent estimate from the New York fed suggests an adequate amount of bank reserves at roughly $2 trillion to support smooth market functioning. Bank reserves are currently at 3.3 trillion, indicating a further decline in reserves can be palatable for markets. The treasury general account or TGA. The TGA has fallen to 790 billion from its 1.8 trillion peak in July 2020. And given further fiscal stimulus is unlikely, it should stabilize around current levels.
Reverse repo, liquidity, and market functioning is a major concern given the spike in short-term rates experienced in 2019, which caused the fed to reverse course. However, liquidity is abundant and reverse repo usage via money market funds will likely remain elevated for some time. What will the market impact be? QE pumped a massive amount of liquidity into the system and now there is too much. Therefore, the initial reduction in the balance sheet shouldn't be a cause for concern. The massive increase in yields and decline in bond prices has already occurred. As a result, the tightening and financial conditions and expected liquidity removal, to some extent, has already been priced into markets. In summary, even as QT commences, long-term rates are likely to trade range bound between three to three and half percent and be little impacted by balance sheet reduction at first. That said, as bank reserves decline to levels that may restrict bank activity, markets will likely signal the fed may need to change its course.
In January, we wrote about our expectations for quantitative tightening (QT) and the impact it could have on markets. Now that the Federal Reserve has ironed out the details of QT and begun the process, below we address the most pressing questions we’re getting from clients:
What are the characteristics of QT?
- The committee will begin to reduce the reinvestments of principal payments in US Treasuries and mortgage-backed securities (MBS) in June 2022.
- Maturing US Treasury securities will be capped initially at $30bn/mo. from June to August, then increased to $60bn/mo. in September. The maturity cap on MBS will initially be set at $17.5bn/mo. and will similarly double to $35bn/mo. in September. Maturing amounts above these caps will be reinvested.
- Under these assumptions, ~$650bn in MBS and ~$1.5trn in U.S. Treasury securities will mature through December 2024, resulting in a ~$2.2trn decline in the Fed’s balance sheet. This would shrink the balance sheet from $8.9trn1 to $6.6trn by end of 2024, well above the pre-pandemic peak of $4.5trn.
How does the withdrawal of liquidity work?
QT is when the Fed receives principal repayments from its security holdings, and rather than use those proceeds to purchase new securities, it extinguishes it and reduces the amount of reserves in the system.2 The removal of liquidity will manifest itself in variable ways on the liability side of the balance sheet via the Treasury General Account (TGA), Reverse Repo Facility, and predominantly in bank reserves.
- Bank reserves – Fed balance sheet has assets and liabilities. If they reduce their assets, then liabilities must balance and similarly decline (bank reserves). A recent estimate from the NY Fed suggests an adequate amount of bank reserves at ~$2trn to support smooth market functioning. Bank reserves are currently at $3.3trn, indicating a further decline in reserves can be palatable for markets.
- TGA – The TGA has fallen to $790bn from its $1.8trn peak in July 2020 and given further fiscal stimulus is unlikely, it should stabilize around current levels.
- Reverse Repo3 – Liquidity and market functioning is a major concern given the spike in short-term rates in 2019, which caused the Fed to reverse course. However, liquidity is abundant and reverse repo usage via money market funds will likely remain elevated for some time.
What will the market impact be?
- Quantitative easing (QE) pumped a massive amount of liquidity into the system, and now there is too much. Therefore, the initial reduction in the balance sheet shouldn’t be a cause for concern.
- The massive increase in yields and decline in bond prices, has already occurred. As a result, the tightening in financial conditions and expected liquidity removal, to some extent, has already been priced into markets.
In summary, even as QT commences, long-term rates are likely to trade range bound between 3.00%-3.5% and be little impacted by balance sheet reduction at first. That said, as bank reserves decline to levels that may restrict bank activity, markets will likely signal the Fed may need to change course.
The Federal Reserve balance sheet
USD trillions
Source: FactSet, Federal Reserve, J.P. Morgan Investment Bank, J.P. Morgan Asset Management.
At its peak, the balance sheet contained $5.8tn in Treasuries and $2.7tn in MBS. *The forecast assumes the Federal Reserve begins balance sheet runoff in June at an intial pace of $30bn in Treasuries and $17.5bn in MBS, then doubling in September. The forecast does not include the active selling of securities from the committee. **Loans include liquidity and credit extended through corporate credit facilities established in March 2020. Other includes primary, secondary and seasonal loans, repurchase agreements, foreign currency reserves and maiden lane securities. Forecasts are not a reliable indicator of future performance. Forecasts, projections and other forward-looking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecasts, projections or other forward-looking statements, actual events, results or performance may differ materially from those reflected or contemplated.
Guide to the Markets – U.S. Data are as of June 6, 2022.
1As of May 31, 2022.
2For more details on the mechanics and flow of capital, please see Cash Crusade: Part 1 and Part 2.
3In the Federal Reserve Overnight Reverse Repo Repurchase Facility (RRP), the Fed takes excess cash out of the system by lending out securities it has on its balance sheet, which it then takes back the next day.
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