(RPT)MNI INTERVIEW: RRP Drop Creates Headroom For Fed QT

(Repeats article first published on July 22)

A USD400 billion drop in uptake from the Federal Reserve's reverse repo facility since the resolution of the debt ceiling debacle is removing a major obstacle to the central bank's plans to keep shrinking its balance sheet by preserving liquidity in the banking system, former New York Fed open markets desk trader Joseph Wang said in an interview.

Earlier market fears that illiquidity would force a premature end to QT have receded following an uneventful rebuild of the Treasury's cash account at the Fed after the debt ceiling resolution last month, said Wang, author of research blog fedguy.com. With excess reserves of USD2 trillion -- counting both bank reserves and cash parked at the overnight reverse repo facility -- QT could potentially continue for at least two more years, he told MNI's FedSpeak podcast.

While conventional wisdom would expect QT to end when eventual rate cuts begin, the U.S. central bank may be inclined to continue running down its balance sheet this time, Wang said.

"The conventional belief is you don't want to step on the brakes and accelerator at the same time. My sense is that they still want to continue to run off the balance sheet, even if they cut rates. I haven't heard anything that would suggest the contrary," he said.

"They would really like the balance sheet to shrink and they would really like their primary tool of monetary policy to be the federal funds rate. So I would expect QT to continue until they reach a size where they think that we're just above that lowest comfortable level of reserves, maybe plus a bit of a buffer."

FRESH DYNAMIC

The U.S. Treasury moved quickly and aggressively to shore up its cash balances last month after Congress suspended the debt limit through 2024, announcing plans to issue over USD500 billion in bills by the end of June. But uncertainty over who would buy the T-bills -- money funds or investors via bank deposits -- worried markets as the latter would have exacerbated existing liquidity concerns.

"If the Fed continued QT and money continued to come out of the banking system rather than the reverse repo facility, then you could hit up upon that lowest comfortable level of reserves level sooner than you'd like," Wang said.

As it turned out, the vast majority of buyers were money funds who exited the Fed's reverse repo facility after largely avoiding bills for the past year and a half. Treasury minimized price risk by issuing very short dated bills and the vast supply cheapened the price, pushing yields over the 5.05% return offered by the ON RRP facility.

"All in all, it's a very smooth transition for the money market funds and for the market as a whole," Wang said. "Now that you have this new dynamic where money funds are again entering the bill market, that provides a channel where liquidity or cash can actually leave the reverse repo facility, go into the Treasury's checking account, and then the fiscal spending gets spent back into the banking system.

"That means that liquidity in the banking system can continue to stay abundant for the foreseeable future, thus giving a lot of headroom for QT to continue for a couple more years, which is I think, what the Fed would have liked it to do."

RESERVE SCARCITY

Fed officials have long maintained that rate sensitivity on the part of money funds would kick in under the right market conditions, attracting flows out of ON RRP and allowing QT to continue, and Wang said that's likely to remain the case as the end of the hiking cycle should mitigate rate volatility and give comfort to money funds. ON RRP take-up is down to USD1.7 trillion from USD2.2 trillion in early June.

QT has thus far trimmed the Fed's balance sheet down to USD8.3 trillion from a peak of USD9.0 trillion, partly offset by lending related to bank sector stress in March.

Bank reserves are at USD3.2 trillion, well above the Fed's rough estimate of reserve scarcity of USD2.5 trillion, Wang said.