Source: Zhitong Finance

The Federal Reserve is about to bring a rare “soft landing” to the US economy, but it faces another difficult challenge: reducing cash in the financial system without disrupting the market.

As the Federal Reserve has shrunk its balance sheet, ended COVID-era support measures, and removed about $1.4 trillion from the financial system, the market is increasingly concerned about when the Fed should stop such cuts.

At the same time, the market is concerned that if cash in the banking system, that is, bank reserves, falls to a certain minimum level, it may cause the market to stagnate or freeze. However, no one knows what this minimum reserve level is, that is, the “right level” required, is uncertain.

According to information, reserves are cash stored by banks at the central bank for daily operations and to meet customers' withdrawal needs. If reserves fall too low, banks may not be able to meet clients' withdrawal or loan needs, affecting their normal operation, which in turn affects the liquidity of the entire financial market.

Last week, Federal Reserve Chairman Powell said that policymakers are close to making a decision to slow the pace of quantitative austerity (QT) to allow reserves to “land smoothly.” Powell said they are watching “some different indicators” in the money market to “tell us when we are close to our target.”

Market sources said that despite the difficult tasks ahead, the Federal Reserve's current focus is to appease Wall Street. The reason this task is difficult is because the boundaries are blurred: the Federal Reserve is trying to adjust bank reserves from “abundant” to “sufficient” without making them scarce.

In other words, the Federal Reserve is trying to control the level of liquidity in the financial system, not only to ensure sufficient liquidity to support economic activity, but also not to allow excess liquidity to cause problems such as inflation. At the same time, the market signals that the Federal Reserve relies on when implementing this strategy are cluttered and difficult to discern, which increases the complexity of carrying out the task.

In fact, it is important for the Federal Reserve to properly reduce, because insufficient reserves can cause interest rates to spike suddenly, disrupt the treasury bond market, and make it difficult for companies to raise capital. Over the next few weeks, the stability of the financial system may be tested as quantitative austerity (QT) progresses and events such as Tax Day on April 15 arrive. These events are likely to reduce the amount of cash in the financial system while increasing the demand for cash. So far, though, the marketplace function still seems to be working properly.

According to reports, in 2019, a sharp rise in short-term financing interest rates forced the Federal Reserve to re-inject reserves into the financial system. Even though the Federal Reserve has established a safety net to support the money market since then, this is still a situation that Federal Reserve Chairman Powell does not want to test again.

In response, Mark Cabana, head of US interest rate strategy at Bank of America, said that it would be “quite a feat” for the Federal Reserve to carefully design a soft landing to keep the banking system at the right level of reserves, but he added that since they have adopted a more tolerant stance, they now have a “considerable chance” to achieve this goal.

He expects that the Federal Reserve may announce in May that it will begin to gradually reduce QT and reduce its monthly holdings of US Treasury bonds by half to 30 billion US dollars. John Willis, an American macro strategist at BNY Mellon, shared the same views on the scale and timing of the reduction.

According to the market sources mentioned above, the indicators that the Federal Reserve may be concerned about include bank reserves, some key interest rates in the money market, and cash in the Fed's overnight reverse repurchase agreement facility.

Adequate reserves

Estimates of the minimum reserve requirements for banks range from approximately $2.5 trillion to $3.3 trillion. The current total reserves are around $3.5 trillion.

Although it may seem sufficient, banks' demand for cash has increased. Cabana pointed out that when QT began in summer 2022, reserves increased from $3.3 trillion to $3.5 trillion. He attributed this to the increase in reserves of lenders due to outflows of deposits following bank failure in March 2023, as well as unrealized losses in their securities portfolios.

Furthermore, reserves may be distributed differently between banks, making it more difficult to determine sufficient reserves, a point Powell acknowledged last week. BNY's Willis said: “Overall reserves seem plentiful, but the Federal Reserve seems to have signs that they are not evenly distributed in the system.”

The Federal Reserve's reverse repurchase facility is an indicator of excess cash. Investors lend cash to the central bank. The facility has been reduced, but the rate of decline has slowed in recent weeks.

There are mixed opinions about when it will be completely exhausted and its impact on the liquidity of the system. Willis anticipates it may drop to zero during the summer, while Cabana believes it won't be completely exhausted until mid-next year. UBS strategists say there may be an increase in the second quarter at the expense of reserves.

Money market indicators

The Federal Reserve said it is watching two money market interest rates: the federal funds rate between banks and the Benchmark Guaranteed Overnight Financing Rate (SOFR), and interest on reserve balances (IORB) paid by the Federal Reserve to banks.

Kabana expects that the Federal Reserve wants the interbank loan interest rate (federal funds rate) to be about 10 basis points higher than the current rate, making it 2-3 basis points higher than the deposit reserve interest rate paid by the Federal Reserve to banks.

On the US Guaranteed Overnight Financing Rate (SOFR), he expects the interest rate to rise by 10-15 basis points, making it 0-5 basis points higher than the interest rate paid by the Federal Reserve to banks.

Cabana said that when investors need to pay interest rates slightly higher than those managed by the Federal Reserve to obtain cash, the total cash in the system may be closer to an adequate level.

These interest rates are likely to rise gradually as reserves decrease, but an imbalance between supply and demand may cause a brief spike in interest rates in the process, as happened in 2019, which will be a sign that the Federal Reserve needs to pay attention to.

“The Federal Reserve will look at interest rates and associated volatility at the same time to determine when quantitative austerity (QT) actually needs to be stopped,” Kabana said.