Five-Year-Old Fed Balance Sheet Dynamics Still Heavy

(Bloomberg) -- As the Federal Reserve continues to shrink its balance sheet, it remains beset by the same problems it faced more than five years ago.

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Although market dynamics have changed, the main question facing policymakers and investors is how to gauge the liquidity of the financial system and avoid the turmoil that forced the Fed to intervene in September 2019 as it reduced its holdings.

Since quantitative tightening began in mid-2022, central banks have reduced assets by more than $2 trillion. Now, several Wall Street strategists expect the Fed to end QE in the first half of the year, given the level of its reverse repo facility, a measure of excess liquidity, its proximity to vacancies and other factors such as bank reserves. They also noted that the recent turmoil in the repurchase agreement market, especially in late September, was not the result of Fed actions, as may have been the case in 2019.

"Some things may have changed since then, particularly that the Treasury market is much larger and issuance is very high," said Deutsche Bank strategist Steven Zeng, speaking to traders in the market. Limitations on intermediation are also “a bigger factor in repurchase volatility than reserve scarcity, which may be a key difference.”

Back in 2019, a combination of factors, including a scarcity of reserves due to quantitative easing, coupled with massive corporate tax payments and Treasury auction settlements, created a liquidity crunch that sent key lending rates soaring and forced the Federal Reserve to intervene to stabilize the economy. . market.

Even now, it's unclear where the reserve shortfall is, although officials say it's the bank's minimum comfort level plus buffers. The balance now stands at $3.33 trillion, a level officially considered ample and about $25 billion below levels when easing began more than two and a half years ago.

To some market participants, the lack of a decline suggests that institutions' ideal reserve levels are much higher than expected, and that some banks are actually paying higher funding costs to hold cash. The Fed's latest survey of senior financial officials, released last month, showed more than a third of respondents were taking steps to maintain current levels.

The debate over adequate reserves and QT stopping points is nothing new. At the January 2019 meeting, then-Fed Governor Lael Brainard warned against looking for the steeper portion of the demand curve for bank reserves, warning that it would “inevitably lead to a spike in funds rate volatility.” ” and “new tools are needed to curb this.” "

Brainard also noted at a later meeting that the end of the Fed's quantitative easing could coincide with fluctuations in reserves related to the approach to the debt ceiling, adding that levels could differ significantly from normal balances.

Soon, concerns about the impact of the debt ceiling on the outlook for foreign exchange reserves resurfaced. In the minutes of the latest meeting on December 17-18, Roberto Perli, manager of the system’s open market accounts, noted that “the possibility of restoring the debt limit in 2025 could lead to significant changes in the Fed’s liabilities, which could have an impact on assessed reserves. Challenging situation.”

A notable change since the 2019 discussions was the establishment of a standing repurchase facility, which was launched in July 2021. Eligible banks and primary dealers use the SRF to borrow funds overnight in exchange for Treasury and agency debt, thereby becoming a source of liquidity. By providing financing at rates set by the Federal Reserve, the goal is to ensure that the federal funds rate does not exceed the central bank's policy objectives.

Back at the June 2019 meeting, Chairman Jerome Powell saw two potential appeals of the SRF: avoiding a spike in the federal funds rate and keeping bank reserves as small as possible.

However, the tool remains rarely used given that balances jumped to $2.6 billion on September 30, the highest level since routine operations became permanent, as end-quarter bank activity pushed funding rates higher. The Fed recently increased morning operations at the end of the year and into the early part of the year to further support market participants.

The main criticism of the facility is that it is not centrally cleared, so any activity adds balance sheet costs. This comes back to the constraints faced by dealers and their ability to act as intermediaries in the market.

“The discussions in 2019 should to some extent influence their thinking about the SRF today,” said Deutsche Bank’s Zeng. At the time, “they viewed excessive and too frequent absorption of the SRF as an adverse outcome and they were concerned about the Moral hazard risks are common to all liquidity support facilities.”