Source: Refinitiv Eikon
BAD NEWS ON THE DOORSTEP
Last year, we argued that liquidity pressures posed a growing threat to financial markets and risky assets.
Central to the argument was that changes in the size and composition of the Fed’s balance sheet would be a headwind for asset prices. Quantitative tightening (QT) was shrinking the size of the balance sheet, and the growing scale of the Fed’s reverse repurchase (RRP) facility was shifting its composition; the net effect was falling commercial bank reserves. Meanwhile, regulation was constraining commercial banks’ appetite to expand their balance sheets, and strong nominal economic growth was shifting the composition of the balance sheet towards activities which support the operations of the economy and away from activities which support the liquidity of financial markets.
“When inflation appeared, it was deemed transitory. When it persisted, there was a pause of disbelief. Then everyone lost their nerve.”
Figure 6 captures the key relationship. Changes in commercial bank reserves held at the Fed – a function of changes in the size and composition of balance sheets – have a close relationship with equity returns.
But why? Bank reserves result from commercial banks deciding to deposit money at the Fed rather than deploying it into riskier activities like loans. In theory, they should not influence asset prices. Yet, in practice, they seem to.
A paper presented at the Fed’s 2022 Jackson Hole conference suggested one explanation.4 It argues that, during QE, banks may seek to increase fees by expanding claims on their balance sheets, such as lines of credit. However, while banks tend to expand these claims during QE, they do not seem to shrink them during QT. This leaves them with less spare liquidity at stress points – for example, when a pandemic causes businesses to draw down all available credit simultaneously.
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. Precautionary demand for reserves can then amplify the tightening liquidity dynamic because reserves are considered the highest quality liquid form of collateral to meet margin calls from central counterparty clearing houses and derivative exposures when markets become stressed. This creates a ‘dash for cash’ liquidity doom loop, like in March 2020.
4 Kansas City Fed (Aug 2022), Why Shrinking Central Bank Balance Sheets is an Uphill Task