Economists warn that a liquidity crisis may erupt in March. Is the end of QT imminent?

Recently, frequent signals have been causing concern in the market. With the Federal Reserve quietly shrinking its balance sheet by US$1.28 trillion, banks' liquidity levels are gradually moving away from their comfort zone.

■ RRP may be exhausted in March:

The Fed is currently reducing its holdings of Treasury securities at a rate of $60 billion per month, which is double what it was five years ago. Continuing to reduce the balance sheet at this pace would increase the risk of rapidly depleting reserves, leading to a spike in money market interest rates.

The balance of the Federal Reserve's overnight reverse repurchase agreement (RRP) facility has "declined faster than expected" and has shrunk to about $603 billion since late August. It could be completely exhausted sometime in March.

The U.S. banking system requires more reserves now than it did five years ago. Bank demand for reserves has been on the rise over the past decade. Once reserves fell below 13% of a bank's total assets, money market rates began to rise.

■ The imbalance in bank reserves is becoming increasingly prominent

Furthermore, the structural imbalance in liquidity distribution between large banks and small banks is very obvious. Before the bankruptcy of SVB, the proportion of cash in total assets of small U.S. banks was already the same as during the "repurchase crisis" in 2019, and current reserves are still being transferred to large banks.

The solvency gap between the two is also widening, with delinquency rates for small U.S. banks (not among the top 100) reaching record highs.

On Saturday, Dallas Fed President Logan acknowledged concerns about small and medium-sized banks, saying, "Although liquidity and bank reserves in the financial system remain sufficient, individual banks may begin to experience tight liquidity. Especially with the ON RRP balance close to zero, there will be more uncertainty in the overall liquidity situation."

■ BTFP will end as scheduled

The temporary rescue tool BTFP launched by the Federal Reserve after the collapse of Silicon Valley Bank could also be ended in March. The interest rate for institutions to borrow funds from the BTFP mechanism is approximately 4.93%, and the interest rate for depositing cash into accounts with the Federal Reserve is 5.40%, so there is risk-free arbitrage income. Officials from the Federal Reserve have stated that the emergency loan program BTFP will end in mid-March as scheduled.

■ Repo rates "occasionally" jump

Repo rates are a price signal of liquidity stress. Experience shows that stress often emerges first during periods when liquidity is unusually constrained or drained rapidly, such as tax dates, Treasury settlements and month-end.

So, between November and December and at the end of the year, there was a sudden jump in the Secured Overnight Financing Rate (SOFR). As the balance sheet reduction continues and U.S. debt collateral increases, the pressure for SOFR to jump more frequently should be obvious.

Bank of America's economist Mark Cabana said, “Recent repo rate pressures have raised questions about the adequacy of cash in the funding system. If repo rates continue to jump sharply, it could signal a lack of excess cash in the financial system, the need to use the SRF, and the possibility that the Fed may end QT early.”

■ Slowing global inflation could pave the way for policy easing

Although the U.S. CPI rebounded slightly in December, economists predict that inflation is likely to fall again in January and may be below 3%.

Fed Chairman Jerome Powell has shown a preference for easing policy before inflation reaches 2%. This makes sense since it will be too late if the Fed waits until inflation reaches target to start an easing cycle.

Inflation in Europe has also slowed faster than the European Central Bank expected. Compared with the inflation forecast data in September 2023, the forecast given by the European Central Bank (ECB) in December has been significantly reduced, but it is still about 20bp higher than the actual core inflation in December. Goldman Sachs believes that recent discussions by the European Central Bank (such as Schnabel's remarks) seem to be slightly behind the curve, and they will eventually have to face the reality of a sharp decline in inflation. GS expects Europe’s headline CPI to fall below 2% in the second quarter of this year and core inflation to fall below 2% in the third quarter.

European Central Bank Governing Council member Vujcic released some dovish remarks over the weekend. He mentioned that although he is more inclined to cut interest rates by 25 basis points, he does not rule out the possibility of a 50-basis point interest rate cut.

In addition, European Central Bank President Lagarde mentioned that once it is determined that inflation could reach 2%, the European Central Bank will begin to cut interest rates. If nothing else, the inflation data for January and February should give the ECB a clear picture of the continued slowdown in European inflation before its March meeting.

■ Is the end of QT, and even a new round of QE on the way?

Recently, Nick Timiraos, as Powell's favorite media mouthpiece, confirmed that QT's days are now numbered, writing that "Fed officials are to start deliberations on slowing, though not ending, that so-called quantitative tightening as soon as their policy meeting this month. It could have important implications for financial markets."

Dallas Fed president Lorie Logan also said the Fed's QT is effectively over due to the sudden, unexpected slide in systemic liquidity, primarily related to the rapid drain in the reverse repo facility.

The reason for the Fed's panic is that the central bank wants to avoid the same repo market cataclysm that caused both the liquidity drain in Sept 2019 and the violent eruption in basis trades that sparked bond market contagion in March 2020.

JPMorgan recently commented on the wind-down of QT: "We now expect that the FOMC will have the outline of a timeline at the January meeting, communicated mid-February minutes to that meeting. We expect that this plan will be formally agreed to at the mid-March meeting and will be implemented beginning in April." JPM noted that the monthly cap on the runoff of Treasury securities is expected to be reduced to $30bn/mo from $60bn/mo.

There is even discussion in the market about whether there will be another round of QE. However, this may lead to more severe inflation, so an upgraded version of the BTFP patch package is more likely.

In general, after several years of tightening, 2024 is when the liquidity floodgate likely reopens, and not only does the Fed start to cut rates aggressively, but it's also expected that the slowing down or end of QT will likely be launched soon.