Quantitative Tightening in Progress: Should We Worry About It?

As interest rate hiking comes closer to an end, quantitative tightening has gradually become another topic of market concern.

The central banks have only got a couple of experiences of QT. Japan did it in 2006 and 2007. The US did it from 2017 to 2019. During both periods, stock markets had above-average volatility.

We can observe liquidity from two indicators: reverse repos and commercial banks' reserves at the Federal Reserve.

Indeed, the balance of the reverse repurchase window has been declining rapidly as planned this year, which is a sign that market liquidity is decreasing. However, it is only one side of the story. In contrast to the decline in reverse repo balances, commercial banks' reserves at the Fed have actually risen this year. This means cash is declining at a slower rate than expected.

As Dallas Fed President Logan said in a speech on Friday, the Fed is now aiming to move from "abundant" reserve levels to just "adequate" levels. The New York Fed's rule of thumb is that a reserve level of 8% of nominal GDP is the minimum range for "adequacy." The chart by Financial Times shows how far it is currently from crossing that threshold:

Joseph Wang, who worked at the New York Fed when QT was first launched, said he was not worried that funding markets would collapse anytime soon, given the Fed's liquidity facilities and the amount of cash stuck in the system.

Goldman Sachs analysts don't think there's much to worry about QT. A recent report by the company noted, “We expect the FOMC to begin considering changes to the speed of run-off around 2024Q3, to slow the pace in 2024Q4, and to finish run-off in 2025Q1.” The determining factor for the Fed's timeline will probably be the amount of reserves available to banks.

GS echoes some Fed economists to estimate that the Fed will stop balance-sheet roll-off when reserves make up 12 to 13 percent of bank assets. They give their full projected timeline below:

Here's another problem with QT: The Fed not only drains cash, it stops buying Treasuries. The concern is that bond liquidity that could have been reinvested by the Fed is now being drained from the financial system. The US Treasury can no longer count on always having a portion of its outstanding bonds rolled over by the Fed. Instead, new private buyers must refinance it, and the future of the treasuries depends very much on whether the Treasury Department can control its spending.

As the Federal Reserve maintains high interest rates for a longer period of time, the pressure on fiscal interest expenditures has increased significantly. As of October this year, the federal government’s interest expenditures accounted for 11% of total expenditures (12-month moving average). Under the neutral scenario, the proportion of interest expenditures in GDP is expected to rise to 2.7% next year, and the proportion in total fiscal expenditures is expected to rise to 13%, both of which are lower than the high levels in the 1990s.

This gives the Treasury Department some space, but the bipartisan decisions on next year's budget will still become a variable in the future Treasury market and further affect the Fed's QT process.