“In essence, reserves are not nearly as abundant as the headline numbers suggest. So, as monetary tightening drains reserves, this bites on market liquidity sooner than expected.”
THEM GOOD OL’ BOYS WERE DRINKING WHISKEY AND RYE
If your eyes are glazing over, here’s an analogy: even if the party doesn’t need more punch, you can’t drain the punchbowl, because too many partygoers have intravenous drips connected to it. Faced with the excess liquidity created by QE, the financial system has adapted in ways which make it hard to tighten monetary policy without causing financial stress.
‘Eureka!’ Don’t we have an Archimedes’ principle for financial markets? If we can predict how liquidity will behave, we can anticipate the direction of financial markets.
Sadly, predicting reserves is not straightforward. The relationship between bank reserves and markets seems to have two-way causality.
Exogenously driven changes in reserves impact markets; but market movements can also drive changes in reserves. And the relationship is even less predictable in the current monetary policy framework. That’s because the RRP facility can either dam up or release liquidity, depending on what different agents in the financial system are doing.
At times, one side of this relationship will prevail over the other. For example, if exogenous news is not supportive of markets, Fed shrinking of reserves via QT is likely to be a headwind for equities. The challenge is predicting the behaviour of the many different agents.
“Even if the party doesn’t need more punch, you can’t drain the punchbowl, because too many partygoers have intravenous drips connected to it.”
Depositors (retail and institutional) – will they move money from low yielding bank deposits to much higher yielding money market funds (MMFs)?
- MMFs – will they seek to invest in very short duration assets like the Fed RRP or longer duration assets like 3-12 month T-bills?
- Other investors of various flavours – will non-bank risk takers be willing to pay a premium over the Fed’s RRP rate to secure funding from MMFs, thus reducing the RRP balance sheet?
- US Treasury – how will it manage the balance of its Treasury General Account (TGA) held at the Fed? Might it engage in a treasury buy-back operation in the bond market?
- Commercial banks – will banks want to expand their gross or risk weighted assets, given current regulatory constraints?
- Regulators – will they ease the supplementary leverage ratio (SLR), which could increase banks’ balance sheet flexibility?
- The Fed – will it continue quantitative tightening into a slowing economy?