MNI: Fed To Press Ahead With QT Amid Liquidity Concerns

Record investment in the Federal Reserve’s reverse repo facility is amplifying the effect of quantitative tightening in draining cash from the banking system and renewing concerns over Treasury market functioning, but the threat of dwindling reserves is unlikely to derail Fed QT, current and former senior Fed staffers told MNI.

The Fed calculates that market mechanisms will automatically shrink RRP demand over time. Regulators are also preparing a recalibration of bank capital requirements this fall expected to include a modification to the supplementary leverage ratio, making holding reserves more attractive to big banks.

"The unlikely event is that we would reach a point where reserves are close to minimum and we still have a chunk of money in the overnight RRP," said Richmond Fed economist Huberto Ennis.

"Once you start having lower levels of reserves in the banking system, the effective fed funds rate is going to start creeping higher in the target range, and repo rates are going to move a little higher as well. These consistent changes in spreads will incentivize money market funds and other investors in the RRP to move money away from it."

RESERVE SCARCITY

Reserves have dipped to USD3.0 trillion from their peak of USD4.3 trillion in December 2021, two years ahead of schedule based on New York Fed projections in May, when the FOMC launched its aggressive balance sheet reduction plan under the assumption that QT would first drain the RRP facility.

The opposite has occurred. Due to private sector balance sheet constraints and a shortage of short-dated Treasuries, money market funds and others plowed a record USD2.426 trillion into RRP at quarter-end, up some 25% from May.

At the current pace, analysts say reserves could reach the Fed's target by spring. The New York Fed projections saw reserves bottoming at around USD2.3 trillion in 2026, a level the Fed deems "ample" for funding markets to operate normally without frequent interventions from the central bank. Some Fed economists say that minimally "ample" level may actually be higher at 11% of GDP or around USD2.8 trillion.

Too few reserves could spell trouble again for the repo market, especially if a shock causes a flight to safety and RRP usage spikes further. The new standing repo facility is expected to provide a backstop against the type of repo ructions seen in 2019 but has yet to be tested.

LOWERING PARTICIPATION

To lower RRP participation, the Fed would have to cut the yield or shrink its cap on per-party transactions. The RRP's relatively high return -- the offering rate rose to 3.05% after last months' rate hike -- and safety in a volatile environment are also attractive features.

But repricing the facility would put downward pressure on already-low short-term interest rates, said Francisco Covas, a former Fed Board economist who's now head of research at the Bank Policy Institute lobby group. The RRP helps set a floor under short-term interest rates by taking cash in exchange for Treasuries.

"Lowering the RRP offering rate is not attractive because SOFR is below the target range, and the fed funds rate is toward the lower end of the range and just 3 bps above the RRP rate," Covas said. "They want to keep the fed funds rate well within the target range."

Likewise a tighter cap on participation would pressure money market rates without addressing the underlying structural issue -- that of a regulatory environment that discourages banks from holding riskless reserve balances, Covas added.

SLR FIX

SLR reform would go some ways to enlarge the intermediary capacity of dealers. A Fed Board study published in August found evidence that "banks' ability to participate in markets for safe assets may be curtailed by leverage regulations,” based on an analysis of confidential supervisory data on daily holdings of Treasury securities by the five U.S. banks with the largest Treasury market footprint.

The Fed has signaled it will consider permanently excluding reserves from the SLR denominator as part of a broader review of the capital framework this fall. Regulators are seeking to implement the final phase of Basel III, expected to tighten risk-based capital rules without sharply lifting overall requirements.

Still, some investors and regulators cast doubt on the ability of SLR reform alone to shore up Treasury market resilience. The hedge funds that now comprise half the interdealer market are not yet regulated as broker-dealers and have little obligation to act as shock absorbers in times of volatility. The SEC has proposed requiring registration of some nonbank trading firms and rules to boost the use of central clearing as part of a wider effort to improve market functioning. (See MNI INTERVIEW: Stein–Troubled Treasury Market Needs Reform)