QT Tapering Looms Despite Macroeconomic Conditions: Fear of Liquidity Squeeze Drives Policy

Summary:

• To prevent T-bills from accelerating their runoff from the Fed balance sheet, QT tapering is set to commence in June.
• By reducing the QT cap from $60 billion to $30 billion per month, as stated in the latest FOMC minutes, the Fed aims to reduce the runoff of T-bills from June 2024 to June 2025 to $3 billion instead of $205 billion if QT is not tapered. Simultaneously, the Fed will retain approximately $240 billion in coupon bonds over the same period versus $53 billion if the QT cap is not changed.
• QT tapering will allow the US Treasury to expand the auction size of coupon bonds, facilitating the financing of a burgeoning fiscal deficit.
• The yield curve is expected to continue steepening, with QT tapering likely benefiting the front end while the long end will continue to remain vulnerable to elevated coupon bond issuance.

The Federal Reserve will taper Quantitative Tightening (QT) to avoid a liquidity squeeze.

Irrespective of the macroeconomic landscape, QT tapering is inevitable for one reason: policymakers are wary of reaching the threshold of "ample reserves" in the coming months, fearing a liquidity squeeze akin to what occurred in 2019.

In the latest FOMC minutes the willingness of policy makers to taper QT as soon is possible is clear.  “In light of the uncertainty regarding the level of reserves consistent with operating in an ample-reserves regime, slowing the pace of balance sheet runoff sooner rather than later would help facilitate a smooth transition from abundant to ample reserve balances”.

The notion of "ample reserves" remains somewhat abstract, as the exact threshold where reserves become scarce is uncertain. However, according to a St. Louis Fed paper, reserves at approximately 10% to 12% of nominal GDP—equating to between $2.7 trillion to $3.4 trillion based on 2023 year-end GDP levels—would be considered ample. With the Reverse Repurchase Facility recently dipping below $500 billion and projected to reach zero around summertime, the depletion of bank reserves at the Fed is imminent. Currently, bank reserves at the Fed stand at $3.4 trillion, aligning closely with the St. Louis Fed's conservative estimate of the ample/scarce reserve threshold.

QT will start in June.

If the Federal Reserve doesn’t initiate QT tapering by June, it risks intensifying the divestment of Fed T-Bills, exacerbating the strain already placed on the RRP facility.

We advocate for the implementation of QT tapering in June for the following reasons:

1. The Fed's goal is to expand its proportion of T-Bills on its balance sheet rather than shrinking it. That’s clear from a recent Chris Waller speech where he states he “would like to see a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities. Prior to the Global Financial Crisis, we held approximately one-third of our portfolio in Treasury bills. Today, bills are less than 5 percent of our Treasury holdings and less than 3 percent of our total securities holdings.”. If the $60 billion per month QT cap is not reduced by June, an estimated $205 billion in T-Bills will be divested from June 2024 to June 2025.
2. The US Treasury needs to increase coupon bond issuance to finance a swelling fiscal deficit. That means that if the QT cap is not lowered, more pressure will be applied on US Treasuries, causing yields to rise further and make fiscal deficit unsustainable.

The QT US Treasury cap may be halved. What are the implications?

The latest FOMC minutes goes quite into detail regarding QT tapering and say that “participants generally favored reducing the monthly pace of runoff by roughly half from the recent overall pace.” That figure is not provided randomly.

By lowering QT cap from $60 billion to $30 billion, the Fed will be able to achieve the following from June ’24 to June ’25:

• T-bills running off the Fed balance sheet will amount to only $3 billion. If the $60 billion cap is not changed, $205 billion T-bills will be runoff.
• Approximately $240 billion in coupon Treasury bonds will not be phased out ($187bn more compared to a QT cap of $60b). This equates to roughly $60 billion per quarter, which could potentially offset any further increases in the size of Treasury auctions for coupon bonds.

What is the impact on bond markets?

The yield curve is expected to continue disinverting and steepening. QT tapering is likely to benefit the front part of the yield curve, leading to a decrease in yields. The long part of the yield curve may experience some relief from the reduction in Quantitative Tightening (QT), but the US Treasury's need to maintain elevated coupon bond issuance might offset this.