How Will the Upcoming End of Quantitative Tightening Impact the Market? Here's What Wall Street is Buzzing About

The Federal Reserve has recently been sending frequent signals about slowing down the pace of its asset shrinkage and ending the Quantitative Tightening (QT). The rapid depletion of balances at the overnight reverse repurchase agreement (RRP) facility has caused anxiety in the funding market. Wall Street analysts are discussing when this 18-month-long QT will come to an end and how it will affect the market.

Since the commencement of the current round of QT in June 2022, the Fed has been allowing as much as $60 billion in Treasuries and as much as $35 billion in agency debt holdings to mature every month. This has resulted in a shrinkage of the Fed's assets by over $1.2 trillion, from over $8.95 trillion to $7.68 trillion, in the past 18 months - a pace nearly twice as fast as the previous QT phase that took place between 2017 and 2019.

The scenario of slowing and ending the balance sheet reduction has been under discussion in the December Fed meeting. Some participants suggested that the Fed could slow and eventually halt the reduction of its balance sheet when reserve balances were slightly above the level deemed sufficient, and recommended that the committee should start discussing the technical factors to guide a slower pace of balance sheet reduction before making a decision.

Barclays' FICC team believes that this is a preliminary step towards ending QT.

This suggests that the current round of QT, which has been ongoing for 18 months, may end earlier than initially anticipated. After the FOMC minutes were released, some analysts, such as Bob Michele from JPMorgan Asset Management, adjusted their perspective and currently anticipate the balance sheet run-off to be completed by the summer of 2024.

Speeches last weekend by Dallas Fed President Lorie Logan further fueled market speculation that the Fed would halt its QT.

According to research by Barclays, the Fed is expected to use two broad sets of indicators as guidance, including money market rates (such as SOFR and the federal funds rate) and broad liquidity measures such as bank reserves.

Barclays expects the Fed to monitor the trading activity of SOFR and the federal funds rate relative to IORB and RRP rates, with a particular focus on the FF-IORB spread. Data shows that the federal funds rate has consistently traded below the IORB, with little fluctuation in the spread since the start of this round of QT. This means that “higher repo rates would attract the Fed's attention if there is regular use of the SRF as this might pull the funds rate higher”.

The Fed's broad liquidity measures encompass not only the level of bank reserves but also their distribution across institutions. FOMC minutes reveal that the Fed will slow and eventually halt the reduction of its balance sheet when reserve balances are slightly above what is deemed ample levels of reserves.

Data shows that, despite a slight overall increase in bank reserves in the Federal Reserve's liabilities since the start of this round of QT, the challenge lies in determining where precisely these ample levels of reserves lie. Moreover, bank reserves have already begun to trend downwards since the end of December last year. Additionally, with the trend of overall reserve growth mostly flowing to large banks, it is challenging to ensure broad sufficiency of reserves for all institutions.

Despite that the current balance sheet reduction has primarily been achieved through the Fed's reverse repurchase agreements, bank reserves have not appeared to be significantly shaken. However, with the depletion of these reverse repo agreements, there is a theoretical and empirical risk of a decline in bank reserves. Therefore, analysts believe that the rate at which the tool balance of RRP is consumed will determine how long the QT can be sustained.

Data shows that the current balance of US Overnight Reverse Repurchase Agreements is only $679.96 billion, a significant decline of over 70% from its peak level of $2,553.72 billion at the end of 2022, with the rate of decline accelerating into 2024. Analysts suggest that the Federal Reserve should completely halt the balance sheet reduction before the usage of RRP approaches zero, in order to ensure that the remaining funds in RRP can be redeployed into the repo market when overnight market volatility arises.

Barclays believes that the Fed will not take the risk of surging financing rates as it did in 2019, and will proceed with caution. Barclays and Bank of America have the most optimistic predictions for the Fed's exit from QT. They predict that the Fed may slow down its balance sheet reduction in April and end QT in June or July.

Deutsche Bank stated that if the Fed begins to cut interest rates in response to a potential economic downturn, the earliest the Fed could end QT would be in June. However, if the economy experiences a soft landing, the Fed may extend QT until next year.

Morgan Stanley is more cautious, stating that the decision-making body hopes to give the market sufficient time to prepare and may not take action until September.

Ending QT could decrease the amount of debt that the Treasury needs to issue to private investors this year. According to Meghan Swiber, a US rates strategist at Bank of America, if QT ends in June, it is estimated that issuance (excluding Treasury bill issuance) for this year will be $1.8tn, compared to $2.1tn if QT ends in December.

The anticipated end of QT is undoubtedly a significant tailwind for the bond market. The Federal Reserve is expected to reinvest its maturing treasuries and mortgage-backed securities into the US Treasury market, which will support US Treasury yields. This is especially important given the expanding fiscal deficit and the possible decrease in demand for US Treasuries from large foreign buyers. The Fed's re-entry into the market is expected to provide a boost to the Treasury market.