- There are early signs of stress in the USD plumbing system.
- As QT progresses, we think that stresses during the year-end cross would show up more significantly.
- USD liquidity should become relatively flusher.
- USTs have one less headwind to contend with.
The Federal Reserve would likely end quantitative tightening (QT) some time in 1H25. To recap, QT is the reverse of quantitative easing (QE). As financial and economic conditions improve post the worst of the 2020 pandemic, there no longer is a need to employ extraordinarily loose monetary policy (short rates at zero and very flush liquidity conditions). Accordingly, some of the liquidity that got pumped into the financial system needs to get withdrawn. Our estimate of excess liquidity (excess reserves and placements in the Fed’s RRP facility) peaked at around USD 3.5tn in 2021. Since then, our measure of excess liquidity has fallen close to USD 2tn with the pace of QT slowed to a cap of USD 60bn / month. Below, we lay out our thought process on why QT probably needs to stop within a year.
Is excess liquidity measured correctly?
Our measure of excess liquidity with two assumptions - banks would require the same ratio of reserves for operational purposes as was the case pre-pandemic (2015-2019) and that the RRP usage can also fall back close to zero (levels seen pre-pandemic). When the Fed was running QT in the mid-2010s, liquidity got overly tight. Our measure shows that excess liquidity dropped to zero in 2019 and that led to stresses in short-term USD rates (repo, FFR etc). Once the Fed figured out the issue, QT was stopped immediately. There is no guarantee that these assumptions will hold. It is plausible that banks and financial institutes now prefer holding higher levels of precautionary liquidity (either as reserves or placed in the Fed’s RRP facility). In which case, it may not make sense for the Fed to apply the same metrics that worked back then to the current state. In other words, excess liquidity may be substantially less that than the USD 2tn that we have put forth.
Warning signals to watch for
Market based measures would be timelier in determining if the financial system is facing a crunch. Back in 2019, repo rates, SOFR and the effective Fed Funds rate showed a clear updrift even as the Fed kept policy rates (FFR and interest on reserves) steady. Back then dealer balance sheets were also bloated and probably impaired their ability to provide liquidity. Keeping in mind these points, we can apply these to the current situation. In more recent months, we note that tightness in the repo space is becoming more common place. Stickiness now extends beyond seasonal factors (month-end, quarter-end). When we smooth out the fluctuations, we note that SOFR fixings are shifting higher relative to the FFR, an early sign that there could be plumbing issues ahead. There is also the added similarity that dealers are now holding a lot of USTs on their balance sheets. Meanwhile, there is no sign of stress in the effective FFR, suggesting that reserves are still ample. To be sure, this suggest that there are two tiers – reserves are still flush, but repo funding is starting to get constrained. The big challenge will come towards the end of year when funding historically becomes the tightest. A funding scare at that point would probably prompt the Fed to end QT in the subsequent months. If the one-month average SOFR fixing goes 15bps above the FFR (lower bound), that should be taken as a warning signal that liquidity is tight. We think that the effective FFR would likely be lagging as an indicator.
Implications of the end of QT
QT reduces the amount of USD liquidity in the system. All else equal, it means that the USD should be more flushed vis-à-vis other currencies once QT ends. In the rate space, this should drive USD basis higher, but the impact will likely be felt over an extended period. Sentiment and other shorter-term factors would still be more important in driving basis swaps. Second, there will be less of a headwind for USTs as the Fed will be holding its stock of securities steady. Currently, market participants have to deal with large issuances and QT.
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