The Fed has been working QT for some time and but there’s nonetheless plentiful liquidity within the monetary system.

Fed’s bond holdings are down $1.3 trillion from their peak (as a result of QT), but solely half of this supposed tightening has impacted financial institution reserves (aka liquidity) that are down a meager $0.7 trillion.

This ongoing “cash thriller” has caught many off-guard, and it has helped gasoline a number of bullish narratives: probably the most well-known one being that greater ‘’liquidity’’ has supported inventory markets in 2023.

2024 is shaping to be one other 12 months the place financial plumbing will matter an amazing deal.

To know the mechanics behind this cash thriller, let’s begin from QT.

Listed here are 5 easy steps to grasp how Quantitative Tightening works:

Step 1-2: the Fed doesn’t reinvest maturing bonds (1) from its QE portfolio (= performs passive QT) and subsequently destroys reserves (2) – also called “liquidity”;

Step 3-5: the federal government must roll over its funding, however the Fed isn’t rolling over its bond holdings (3).

Banks now must step up and take in extra of the newly issued securities (4-5).

The ensuing stability sheet adjustments are summarized within the backside tables: the Fed reduces its stability sheet by 100 which sees a 1:1 discount in reserves (aka ‘’liquidity’’) as banks should step as much as take in bond issuance.

That is how QT usually works.

But one thing totally different is occurring this time.

Again in 2021, the Fed had a problem: charges had been at 0%, and there was an excessive amount of cash within the system.

Cash Market Funds (MMF) had been bidding up T-Payments a lot that yields had been testing unfavorable ranges (!), and so to stabilize cash market charges the Fed proposed a pleasant different: the Reverse Repo Facility (RRP).

This inspired MMF to park cash on the Fed, they usually did in enormous measurement: the RRP reached $2.5 trillion.

You possibly can consider this as pent-up ‘’liquidity’’ saved in a nook of our monetary system.

Right here is the factor.

In 2023 MMF has unleashed this pent-up power: the RRP utilization has dropped materially, and this wave of supportive ‘’liquidity’’ has been thrown at markets.

And that is prone to proceed in 2024.

How does this work?

As at all times, let’s examine our stylized stability sheets to seek out the solutions:

MMFs drain down their enormous RRP balances (orange) they usually purchase T-Payments (inexperienced).

The federal government has to roll over debt whereas the Fed does QT (purple), however this time the slack is picked up by cash market funds and never by banks.

The result’s that QT doesn’t drain ‘’liquidity’’ however the RRP takes the hit (blue circle).

Successfully, we’re working a sterilized model of QT:

In different phrases, the Fed is lowering its stability sheet however not draining the ‘‘extra liquidity’’ (financial institution reserves) from the system.

A liquidity conundrum.

So, what occurs subsequent?

The RRP facility is down from $2+ trillion to $600 billion, so this ‘‘sterilization’’ mechanism can work for a bit longer in 2024 however it is going to in the end come to an finish.

And dwindling liquidity may cause lots of bother within the largest financial plumbing machine on the earth.

The repo market.

Claiming that the quantity of reserves (‘‘liquidity’’) within the banking system someway impacts asset costs is outright fallacious: banks don’t use reserves to purchase shares, and that’s why the supposedly direct relationship between adjustments in liquidity and inventory market returns doesn’t exist.

Nonetheless, banks do use reserves to interact in repo market actions with one another. And that issues.

Because the chart above reveals, the requested premium to lend cash in repo markets towards merely depositing on the Fed is slowly growing – ranges aren’t worrying but, however there appears to be a development in place.

The purple circles within the chart present how unhinged repo markets turned in 2019.

Listed here are the 7 steps to the true financial plumbing danger forward for 2024:

• The Fed continues QT however MMF stops immunizing the unfavorable impact on liquidity;
• Financial institution reserves take a severe hit, and banks’ urge for food to interact in repo markets declines;
• The US Treasury continues to problem giant quantities of bonds;
• The imbalance between collateral (bonds) to soak up and accessible liquidity (reserves) grows;
• Repo charges steadily enhance signaling extra strains within the financial plumbing enviornment;
• Leveraged gamers counting on regular repo charges blow up;
• Deleveraging happens.

Briefly: the cash trick that made QT appear like a stroll within the park in 2023 would possibly as effectively disappear later in 2024.

This can be a very underestimated danger that nearly no one has on their radar.

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