Why the Fed's reduction in the pace of QT is critical for markets

While many are focused on interest rates, the likely bigger near-term driver of markets is the Fed's decision to taper QT while reserves remain abundant and the deficit remains unsustainably large.

I previously elaborated on the importance of the outlook for QT following the March FOMC meeting in a research piece titled “Fed turns increasingly dovish, adding further fuel to financial markets”. The below paragraph is an excerpt from that piece:

With Fed Chair Powell revealing that a tapering of QT is set to happen “fairly soon”, which would see a taper delivered despite reserves still being abundant, and as further large federal government net T-bill issuance is expected to drain the RRP facility and inject significant additional “idle” funds into the “real” economy during 2H24 (which creates a further tailwind for bank reserves), the Fed has provided significant further fuel for asset price growth.

Following the equity market sell-off in April (which was potentially liquidity driven: note that I warned about the Q2 reduction in net T-bill issuance back in February within “What the latest US Treasury QRA means for the economy & markets”), I am therefore not all surprised to see the market rebound significantly in the wake of the Fed’s decision to reduce the monthly pace of decline in its Treasury holdings to $25bn (from $60bn) from June onwards — since the Fed’s May FOMC meeting, the S&P 500 has risen 3.7% and is now within striking distance of its all-time closing high that was reached in March, while gold and silver prices have rallied 2.8% and 6.5%, respectively.

The combination of abundant reserves and very large federal government deficits makes the tapering of QT particularly pertinent

Albeit at a slower pace, given that QT is still continuing, many may assume that this will have a contractionary impact on the economy and markets. While this is true if QT is looked at in isolation, when viewed in the context of overall liquidity levels and the federal government deficit, a material contraction in net liquidity currently looks unlikely to occur in 2H24.

Starting firstly with overall liquidity levels, the first thing to note is that bank reserves remain abundant. This can be inferred from the fact that the Fed’s reverse repo (RRP) facility continues to hold ~$450bn-$500bn. The Fed’s RRP facility can be thought of as consisting of idle/inert funds, and is used by the Fed to mop up excess liquidity in order to put a floor on interest rates. In order to achieve this goal, the Fed pays interest on RRP agreements (the rate currently paid is 5.3%). Given that significant sums are still sitting in the Fed’s RRP facility, this indicates that overall reserves remain not just ample, but abundant.

This is where the federal government deficit comes into play. For while MMFs have been soaking up cash and parking it in the Fed’s RRP facility, higher federal government debt levels provide alternative investments for this cash to move into.

Given that MMFs are subject to rules surrounding the weighted average maturity of their assets, these alternative investments more specifically relate to Treasury bills.

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With Treasury bill yields consistently trading above the RRP rate paid by the Fed, this has encouraged MMFs to shift into Treasury bills as their supply expands.

As a result of the very large increases in the supply of Treasury bills since June and the higher rates that T-bills offer, the size of the Fed’s RRP facility has shrunk by trillions of dollars over the past year.

Though as explained previously in the aforementioned research piece (“What the latest US Treasury QRA means for the economy & markets”) and which can be seen in the chart above via the decline in the outstanding level of T-bills in April, this trend has been delayed temporarily, as Q2 represents the seasonally strongest period for US federal government tax receipts.