Three major signals to warn, liquidity depletion, the Fed ends QT in March?
Recently, frequent and fragmentary signals have been raising concerns in the market, with the Federal Reserve quietly shrinking its balance sheet by $1.28 trillion, and banks' liquidity levels are gradually moving out of their comfort zone.
The first signal is an "occasional" jump in the repo rate.
The second signal is that the RRP may be exhausted in March.
The third signal is that the March bailout tool BTFP will expire and not be renewed.
On the one hand, the rapid contraction of small bank liquidity once pushed the SOFR-RRP spread to its highest level since early 2021, and the small bank crisis may erupt again.
On the other hand, once the high leverage of a large number of basis trades in the U.S. bond market is removed, it may also lead to the rapid spread of liquidity problems in the financial system and serious volatility in the bond market.
Therefore, the market speculates that the Fed will step on the QT end button in March and even restart quantitative easing.
However, while liquidity risks appear to be concentrated in March, fundamentals remain anchored and the financial system is fundamentally different from 2019. The market should not overload the expectation of a rate cut and the end of QT.
The repo rate jumped
The repo rate is a price signal for liquidity pressures.
Experience has shown that stress tends to first occur during periods of abnormal disruption or rapid loss of liquidity, such as tax dates, treasury settlements, and month-ends.
So between November and December and at the end of the year, there was a sudden jump in the Secured Overnight Financing Rate (SOFR). Under normal circumstances, broad money market interest rates are well below reserve rates.
As balance sheet reduction continues and Treasury collateral increases, it should be clear that SOFR is under pressure to jump more frequently.
Bank of America's Mark Cabana noted:
"The recent buyback pressure has raised questions about the adequacy of cash in the financing system. If the repo rate continues to jump sharply, it could signal a lack of excess cash in the financial system, the need for SRF, and the possibility of an early end to QT by the Fed. ”
Further into the banking system, the "structural imbalance" in the distribution of liquidity between large banks and small banks is very obvious. According to data from Sinolink Securities, before SVB's bankruptcy, the ratio of cash to total assets of small banks in the United States was already the same as during the "repo crisis" in 2019, and reserves are still being transferred to large banks.
The solvency gap between the two is also widening, with the delinquency rate of small US banks (non-top 100 banks) at record highs.
On Saturday, Dallas Fed President Logan also acknowledged concerns about small and medium-sized banks, saying, "Although liquidity and bank reserves in the financial system remain adequate, individual banks may start to experience liquidity tightening." In particular, with reverse repo ON RRP balances approaching zero, there will be more uncertainty about the overall liquidity position. ”
RRP depletion
Funds deposited by 94 counterparties in the Fed's overnight reverse repurchase agreement (RRP) facility fell below the trillion-dollar mark for the first time in November and have now fallen back to around $720 billion.
At the current rate of reduction, the Fed's RRP could be completely depleted by around early March.
Reverse repos are not only seen as a "cushion" for bank reserves, but they also play a riskier role in the bond market – funding the surge in hedge fund "basis trades".
In the private repo market, it is the money market fund's cash in the RRP that funds the basis trade. (Chart from the New York Fed shows the status of ON RRP funds financing hedge funds)
This brings together the Fed's balance sheet, money market funds, private repo markets, and the U.S. Treasury market, which still has a lot of issuance demand through basis trading.
Therefore, rather than waiting until the reverse repo is exhausted for bank reserves to fall before it triggers liquidity problems and forces the Fed to stop QT, once the ON RRP is exhausted and the basis trade lacks private financing, the high leverage of the trade is likely to lead to a rapid spread of liquidity problems in the financial system, and the bond market may also experience severe volatility.
The BTFP expires and is not renewed
Another thing, which was also cleared in March, was the BTFP, a temporary bailout tool launched by the Federal Reserve in the wake of the collapse of Silicon Valley Bank.
The BTFP program allows banks to obtain up to a year's advance payments from the Federal Reserve by pledging U.S. Treasuries, mortgage-backed bonds, and other debt as collateral. This allows banks to meet the withdrawal needs of their customers without having to sell bonds at a loss.
On the one hand, BTFP helps banks access liquidity, but at the same time, there are risk-free arbitrage benefits when the usage rate of BTFP soars to an all-time high.
As traders ramped up their bets on a Fed rate cut in 2024, the BTFP facility borrowed funds rate at around 4.93% and then deposited cash into the Fed's account at 5.40%.
Federal Reserve officials have indicated that the emergency lending program BTFP will end in mid-March as scheduled.
Of course, the banking system does not believe that this bit of arbitrage by the Fed will significantly alleviate the pain caused by the rising cost of deposits, and Bank of America expects industry profits to shrink.
End QT!Restart QE?
When liquidity risks are concentrated in March, it seems that the QT slowdown in March is a suitable guess. Even once there is a liquidity crisis in a bank or a basis trade to deleverage, the Fed has to reopen QE to bail out the market.
But judging by Logan's comments, slowing down QT is more akin to a precautionary deceleration.
"As the FOMC nears the end of its balance sheet reduction, more cautious action is desired. ”
Since the balance sheet has been reduced twice as fast as in the previous cycle, the current allocation of reserves is also more uneven, and the risk of currency market dysfunction is higher.
Therefore, slowing down the pace as soon as possible will give more time to smooth the allocation of reserves between banks, thereby reducing the risk that market failures will force the Fed to suddenly stop QT early.
Logan said the Fed should slow down QT when RRP trading volume is close to "low".
As for restarting QE, we don't see this as a baseline option, and QE in the true sense of the word.
It is true that as liquidity shrinks, risks from small banks, Treasury issuance, and basis trading are accumulating. But whether and when it will erupt is difficult to determine.
After all, as we have analyzed above, despite the depletion of RRP and the expiration of BTFP, the Fed also has two policy tools, the Domestic Standing Repo Facility (SRF) and the International Repo Facility (FIMA), which have improved the "interest rate corridor" mechanism to prevent overnight interest rates from frequently breaking the interest rate ceiling in the process of tightening liquidity.
In addition, Fed officials have openly encouraged lenders to use the central bank's discount window for financing, hoping that this financing tool will be used as an important tool to maintain financial stability and monetary policy.
Therefore, the significance of repo rate fluctuations and BTFP should not be overstated.
Given the current balance sheet adjustment flexibility and basis trades, the financial system is indeed increasingly affected by the supply of U.S. bonds, and the "structural imbalances" between large and small banks are also intensifying.
In the event of a liquidity shock in the small bank or hedge fund market, it is not so much a QE as a BTFP upgrade patch pack. This is not the same as in 2019, where QE is based on the recognition that banks' overall liquidity and reserve supply are already in deficit territory, or that economic inflation is in overcooling territory.
As tightening is coming to an end, balance sheet deleveraging is expected, even necessary. However, the market should not overload the expectations of interest rate cuts and the end of QT.
After all, after this unusually difficult battle on inflation, central banks may be as cautious about monetary easing as monetary tightening in the future.