In the medium term, we think the Fed will convince markets it intends to keep rates restrictive for longer than expected while maintaining its QT policy. So bank deposits will steadily migrate to MMFs in search of higher yields. As a result, RRP balances are likely to grow or remain at high levels. The Treasury is currently running down the TGA as the debt ceiling looms but will rebuild it during 2023. And commercial banks don’t have capacity to aggressively expand their balance sheets, particularly since they are currently facilitating rapid commercial and industrial lending. All these tendencies argue for reserves to fall.
The main offset to this reserves drain comes from an increase in the risk taking appetite of non-bank financial players, which either invest their cash balances or leverage their balance sheets via private funding markets. Many are systematic investors, and this is what appears to be driving markets and reserves higher from the lows of October, triggered by the first signs of inflation and labour markets cooling.
This makes for an unstable liquidity dynamic. Liquidity can seem fine until risk appetite wanes – then suddenly it isn’t. And many more agents now influence changes in reserves than before 2008. So, when the Fed wants to adjust monetary policy, it cannot be sure how it will affect the supply of and demand for reserves.
I SAW SATAN LAUGHING WITH DELIGHT
What’s worse, the Fed can no longer rely on the US treasury market as a source of stability at moments of stress.5
In the September 2019 and March 2020 crises, the treasury market became dysfunctional, requiring the Fed to step in. This is extremely concerning, as the market is supposed to be deep and liquid, representing the global risk-free reference point for free-market capitalism. If it keeps ‘bugging’, that not only makes it hard to operate monetary policy but also unsettles the core of the capitalist system.
There are two elements to the problem, the chronic and the acute. The chronic problem results during monetary tightening in an ample reserves regime when nominal GDP growth is high and commercial banks feel constrained by regulation. Main Street lending crowds out Wall Street financing. In effect, monetary tightening discourages banks from engaging in low margin, more leveraged activities, like treasury repo and FX swap markets.
Why? Because they are balance sheet constrained, banks prefer to focus on higher margin, less balance sheet intensive activities like commercial and industrial lending, for which the growing nominal economy has demand. This reduces the liquidity of the treasury market.
THE LEVEE WAS DRY
The depth of liquidity in the treasury market has declined through time, even as the market’s size has grown substantially (Figure 7).
We can also see how the market’s depth decreases during periods of market stress (2018, 2019, 2020 and more gradually in 2022).
The acute problem arises because reserves are considered the highest quality collateral. When markets become stressed, the need for collateral increases dramatically, leading to a dash away from treasuries into reserves.
This outcome is perverse: monetary tightening disproportionately impacts the liquidity and market functioning of the least risky assets in the market, US treasuries. This makes treasuries unstable when riskier assets start feeling the effects of tightening.
So it is tough for the Fed to gauge the appropriateness of its balance sheet policy, as measured by reserves. The UK’s bond market crisis in September brought these fears to the fore once more.
5 To understand why treasury markets have become this sensitive, see Lev Menand (2022), The Fed Unbound, which analyses the shadow banking problem
Source: Goldman Sachs Global Markets Division, UST 10s, average of amount bid and offered within three levels from mid, five day average. Data to 23 Jan 2023