By Paritosh Bansal
March 28 (Reuters) – As the Federal Reserve braces to execute a challenging soft landing for the U.S. economy, it faces a precarious task: unwinding excess liquidity without unsettling financial markets.
With approximately $1.4 trillion already shed off its balance sheet in a bid to terminate pandemic-induced support, the spotlight now shifts towards determining the ideal moment to halt the process. Concerns loom over the possibility of reserves in the banking system plunging below a critical threshold, prompting potential market turmoil. Unfortunately, the optimal reserve level remains an elusive mystery.
Last week, Fed Chair Jerome Powell hinted at an imminent adjustment to the pace of quantitative tightening (QT) to bring reserves in for a smooth landing. Powell reassured that a variety of money market indicators are being monitored closely to gauge proximity to the desired levels.
The Fed’s vigilance is providing reassurance to Wall Street. Nonetheless, the task ahead is formidable. The challenge lies in navigating the transition from “plentiful” to “sufficient” reserves delicately to avoid inadvertently creating scarcity. Complicating matters further is the noise and ambiguity clouding market signals available to guide the process.
Possible indicators under the Fed’s watchful eye include bank reserves, critical interest rates in money markets, and balances held in the Fed’s overnight reverse repurchase agreement facility, according to market analysts.
Mark Cabana, Bank of America’s head of U.S. rates strategy, described engineering a soft landing as a significant feat. He expressed guarded optimism owing to the Fed’s more accommodative stance, noting that the central bank now stands a reasonable chance compared to the precarious position it found itself in towards the end of last year.
“I would have told you last year, like in November-December, the Fed was very much at risk of missing it,” Cabana remarked.
Transition Period
Analysts anticipate the Fed announcing tapering as early as May by halving the cap on monthly Treasury offload to $30 billion. John Velis, Americas macro strategist at BNY Mellon, shares a similar outlook on the taper’s scale and timing.
The precision of the drawdown is crucial as a shortage of reserves could lead to sudden rate spikes, disrupting Treasury markets and impeding firms’ ability to secure funding. This could be tested in the upcoming weeks, with events like the tax day on April 15 potentially squeezing cash in the financial system while demand intensifies. Thus far, market operations have endured these pressures.
In 2019, a surge in short-term funding rates compelled the Fed to inject reserves back into the system – a move Powell emphasized the Fed is keen to avoid, despite having established a safety net to bolster money markets since then.
Reserve Conundrum
Estimations of the requisite bank reserves range from $2.5 trillion to $3.3 trillion, surpassing the current total of $3.5 trillion.
While reserves appear ample overall, the demand for cash by banks has surged. Cabana highlighted the increase in reserves from $3.3 trillion at the onset of QT in summer 2022 to the current $3.5 trillion, attributing this rise to banks accumulating reserves in response to deposit outflows following bank failures in March 2023 and losses in their securities portfolios.
Moreover, the uneven distribution of reserves among banks complicates determining the ideal threshold – a challenge acknowledged by Powell last week. Velis from BNY Mellon noted that while aggregate reserves seem plentiful, the Fed suspects uneven distribution across the financial system.
One indicator of surplus cash is the decline in the Fed’s reverse repo facility, where investors lend cash to the central bank. The pace of utilization reduction has slowed in recent weeks.
Opinions diverge on the facility’s complete exhaustion timeline and its implications for system liquidity. Velis anticipates depletion by summer, whereas Cabana projects a full drain not until mid-next year. UBS strategists suggest a rise in the second quarter at the expense of reserves.
Monitoring Money Market Cues
Identified indicators under Fed scrutiny include two money market rates – the Fed funds rate and the Secured Overnight Financing Rate (SOFR) – concerning the interest paid by the Fed on reserve balances to banks.
Cabana posits that the Fed should target a 10 basis points elevation in the Fed funds rate and a 10-15 basis points surge in SOFR, maintaining them a few points above what the Fed offers to banks, as the total cash in the system begins approaching adequate levels.
While the rate is anticipated to ascend gradually with declining reserves, short-term supply-demand disparities could result in temporary rate surges, akin to the episodes witnessed in 2019 – an indication for the central bank to heed.
“The Fed will be looking at both the rate and the volatility associated with it to decide when to cease QT,” Cabana concluded.
Declining cash https://reut.rs/3PDMcuL
(Reporting by Paritosh Bansal; editing by Anna Driver)
(([email protected];))
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
