Bankers warn money market rates could hit Fed’s QT plans

Shrinking Fed bond portfolio could squeeze bank liquidity, though money funds remain flush

Market participants are divided on how far the US Federal Reserve will be able to proceed with its quantitative tightening programme before banks start to face liquidity constraints.

“There are some signs of modest… repo funding ripples, where you are starting to see that repo increases a little bit and it stays higher for slightly longer,” said Mark Cabana, short-term interest rate strategist at Bank of America. “We see real risks that they turn into large waves by the end of next year, and the dynamics that are leading to this may indeed force an earlier end to QT than the Fed would have otherwise liked.”

This warning was echoed by Jonathan Wright, an economics professor at Johns Hopkins University, who said he doubted forecasts of another year of QT. Part of the problem is that banks want to hold enough reserve deposits at the Fed to manage their short-term liquidity needs. Fed deposits are seen as more reliable high-quality liquid assets (HQLAs) than holding government bonds, which limits the amount of US Treasuries that banks want to absorb as the Fed moves them off its own balance sheet.

We see real risks that [repo funding ripples] turn into large waves by the end of next year

Mark Cabana, Bank of America

“Any time there’s a shock” to market liquidity, said Wright, “that’s coming out of reserves.” To replenish reserves, banks would have to use the Fed’s standing repo facility that lends banks cash in return for US Treasury collateral. Wright warned: “Unless the SRF is very effective, that runs the risk of losing rate control.”

Cabana and Wright were speaking at an event organised by the Bank Policy Institute on October 5. Speaking on the same panel, Darrell Duffie, professor at Stanford School of Business, warned that the Fed will need to watch more than just the headline pricing signals in the money markets to know when to curb QT.

“One thing that you can see well in advance and a much, much stronger and more precise signal is the time of day by which the leading money market banks are receiving their payments,” said Duffie. “When they get paid later in the day, it’s a sign that money markets are tightening and that is closely related to spikes in the repo rate.”

Reverse repo trend

At present, there are signs of ample liquidity in the financial system, including substantial use of the Fed’s reverse repo (RRP) facility, which allows firms to borrow US Treasuries in return for cash. High RRP balances suggests surplus reserves or a shortage of Treasury collateral in the market. However, data from the St Louis Fed shows a decline in reverse repo usage starting in mid-April.

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“It’s been falling fast. We were at a consensus on how fast we thought it would fall, we thought that 90% of the liquidity drain would be absorbed by RRP and only 10% by reserves,” said Cabana. “If anything, it’s falling faster than we anticipated.”

He advocated the Fed monitoring the use of the SRF as a sign of scarce reserves in the market – although he agreed with Wright that the facility might not be enough on its own to manage liquidity squeezes.

“Is the Fed going to be able to add a trillion dollars of increased liquidity through SRF? No,” said Cabana. “But they will be able to hopefully get enough of a signal that tells them that dealers are using this as an intermediation tool, and that the minimum quantity of liquidity in the system might have been reached.”

Money fund flows

However, on the same panel, Teresa Ho, who runs the US short duration strategy team at JP Morgan, was less convinced that money market rates might begin to spike any time soon. She said any decline in bank reserves was being more than offset by heavy inflows to money market funds (MMFs), which she expected to continue using the RRP.

“If it were that easy to drain RRP, I would argue that RRP balances wouldn’t still be as elevated as they are today, above a trillion dollars, despite QT having gone on for over a year now,” said Ho.

We could definitely be hitting an inflection point by the summer [next year], when the Fed will probably need to decide if and how it can continue QT into the second half of 2024

Teresa Ho, JP Morgan

She said inflows to MMFs are likely to remain high, given their significant pick-up over bank deposits in a high-rate environment. Moreover, she predicted that the latest round of reforms to MMF rules, adopted by the Securities and Exchange Commission on July 12, could drive holdings from prime funds that mainly invest in bank paper, into government funds that hold US Treasuries and reverse repos. Additionally, the SEC rule change has increased the size of liquidity buffers that prime MMFs must maintain – pushing them to hold more Treasuries or reverse repos.

“The last time money fund reforms came through in 2016, they pushed a trillion dollars of cash from prime money funds into government money market funds,” said Ho. “I suspect this [reform] will do the same thing, pushing more money out of prime funds into government money market funds, and then the remaining prime funds will continue to run their portfolios increasingly like government money market funds.”

Ho concluded that the Fed would continue with QT for as long as possible, but acknowledged there could be challenges at some point in the future.

“I think we could definitely be hitting an inflection point by the summer [next year], when the Fed will probably need to decide if and how it can continue QT into the second half of 2024,” said Ho.

Editing by Philip Alexander