By Michael S. Derby
-Some Wall Street analysts now believe the Federal Reserve will pull the plug on its long-running effort to shrink its balance sheet at the end of the month.
These central bank watchers believe the ground has shifted for quantitative tightening, or QT, due to mounting money market friction, which could threaten the Fed’s control over the interest rate target it uses to achieve its inflation and employment goals.
Stopping the withdrawal of liquidity by QT at the October 28-29 Federal
Open Market Committee meeting would help ensure the technical aspects of monetary policy continue to run well, these analysts reckon.
“We expect the FOMC to end its securities runoffs at this month’s meeting,” analysts at Wrightson ICAP said in a note over the weekend. While they’re skeptical genuine liquidity tightness has emerged in money markets, some of the recent turbulence in short-term lending “is clearly a sufficient warning sign to justify moving on to the next phase of the Fed’s normalization plan.”
Evercore ISI forecasters wrote on Monday “we think the Fed will now signal the end of QT at its October meeting with a view to wrapping up before year-end pressures, although the actual end may come a month or two after the announcement.”
Jefferies analysts told clients “we expect that the Fed will completely cease QT at the next meeting at the end of the month,” although the Fed is likely to allow mortgage bonds, which have been very slow to come off its books due to challenging housing market conditions, to expire at the current pace.
The shift in sentiment follows market moves last week that saw some key short-term borrowing rates rise as some financial firms unexpectedly tapped the Fed’s Standing Repo Facility, which exists to provide fast cash loans collateralized by bond holdings.
Also signaling market friction: A rise in repo borrowing costs and the Secured Overnight Financing Rate, as the federal funds rate, the Fed’s main interest rate target, drifted higher in its current range of between 4% and 4.25%.
That all happened as Fed Chair Jerome Powell in remarks on October 14, said QT might end “in coming months,” even as he echoed other Fed officials who have said recently there remains plenty of liquidity in the financial system. Fed Governor Christopher Waller, who spoke in New York on Thursday, said “we're about at that point” where the financial system has the right amount of liquidity, as measured by banking sector reserves.
QT RIP
The QT process is designed to remove liquidity from the financial system added during the COVID-19 pandemic. In a bid to provide stimulus and bond market stability the Fed aggressively bought Treasury and mortgage bonds to lower long-term interest rates.
Those purchases, kicking off in large size in the spring of 2020, more than doubled total Fed holdings to $9 trillion by the summer of 2022. Since then the Fed has allowed a set amount of bonds to mature and not be replaced, taking holdings to the current level of $6.6 trillion.
The Fed has said it seeks to leave enough liquidity in the system to allow for firm control over short-term interest rates and to allow for normal money market volatility. The challenge for the Fed is that it’s unclear how much liquidity it can remove before markets grow too volatile, so Wall Street has struggled to predict when QT would end.
The recent chop in money markets is driven by a number of factors, Fed balance sheet policy included. “There are a number of reasons why this is the case, including some idiosyncratic factors related to tax payment dates, Treasury auction settlements, and increased bill issuance; the biggest factor is the result of the Fed's ongoing balance sheet normalization,” the Jefferies analysts wrote.
Still, the challenge of getting a hold on the amount of money market liquidity that would meet the Fed criteria has kept alive views that QT has further to run, especially as bank reserve levels thus far have been stable and QT has thus far mainly extinguished excess liquidity parked in the Fed’s reverse repo facility. To that end, bank reserves have come down but have been fairly close to $3 trillion for some time.
Goldman Sachs forecasters said after Powell’s speech that “we now expect the FOMC to announce at its January meeting that runoff will end in February,” noting they had expected that announcement at the end of the first quarter.
(Reporting by Michael S. Derby; Editing by Andrea Ricci)
