RESEARCH

How much can the Fed reduce its assets with QT (Fed liabilities set a bottom)?

Typically, when we look at the Fed's balance sheet, we detail its assets: Treasury securities, MBS, repurchase agreements (repos), swaps, SPVs, etc. Under the new quantitative tightening (QT) regime, total assets are down $139 billion from the peak as of their balance sheet released on September 1.

 But it is the liabilities that limit how far Fed assets can theoretically fall below QT. By looking at the path of those liabilities, we can project the theoretical bottom of QT, below which the Fed cannot go.

AXL Capital Management does the following analysis in order to determine the maximum amount of QT and thus, its end.

On each balance sheet, total assets = total liabilities + capital.

It is easy to do without capital: Congress limits the amount of Capital. Total capital is currently $42 billion, which is minuscule, but that's how Congress wants it.

Total liabilities: $8.78 trillion, down $139 billion from the April 13 peak. Liabilities are what the Fed owes to other entities. Let's look at the four largest liabilities, which account for almost all liabilities:

  • Bank reserves: $3.25 trillion.
  • U.S. paper dollars ("currency in circulation"): $2.28 trillion
  • Reverse repurchase agreements (RRP), total: $2.53 trillion
  • U.S. government current account at the Fed: $670 billion

Total liabilities parallel total assets, the only difference being the miniscule amount of capital. But the composition of those liabilities has changed dramatically, as we will see in a bit:

Reserves plummeted by $1.03 trillion since December 2021

Reserve balances peaked in December 2021 after the Fed began tapering its asset purchases. Since then, reserve balances have plummeted by $1.03 trillion, including $59 billion over the past week:

"Reserves" are cash that banks deposit at the Federal Reserve. Banks use their reserve accounts at the Fed to transfer money to and from other banks. They are a liability on the Fed's balance sheet because they are money that Fed owes to banks. The banks on their own balance sheets carry them as assets, and do not call them "reserves" but "interest-bearing deposits" or something similar.

The Fed currently pays 2.4% interest on reserves; they are the most liquid, risk-free interest-paying assets that banks can invest in, and they also figure in banks' regulatory capital.

Alternatively, banks could invest some of this cash in short-term Treasury securities (Treasury bills). The one-month Treasury yield was 2.49% on Friday. But Treasury bills provide less liquidity than reserves. Banks could also send cash to the Fed through overnight RRPs, but the Fed only pays 2.3% of RRPs.

Reserves are a manifestation of liquidity in the banking system that now does not chase other assets.

QE created liquidity which then chased all asset classes and drove asset prices higher.

QT drains liquidity from the financial system, and in general, one aspect of this liquidity drain is falling reserves.

But the $1 trillion drop in reserves, after only $139 billion in QT, is partly due to a shift to RRPs through Treasury money market funds.

 

How far can reserves fall (the Fed's "ample reserves regime")?

As QT progresses, reserve balances will shrink further. How far can they shrink? We have some history on this.

Under the last QT regime from November 2017 through August 2019, reserves fell as expected. But when they hit a low of $1.4 trillion in September 2019, banks stopped lending to the repo market. They had a reason because overleveraged mortgage REITs and some hedge funds borrowing in the short-term repo market to fund long-term bets were running out of liquidity. Fearing contagion from the huge repo market, the Fed stepped in and bailed it out.

He then said his monetary policy is based on a "broad reserve regime," a kind of floor, meaning he wants banks to have "ample" cash on deposit at the Fed. He didn't mention a figure but phased out his repo market bailout once reserves reached $1.6 trillion.

But this time, the Fed has "standing repo facilities."

In preparation for QT, the Fed revived this past summer its "standing repo facilities" that it used to have before the financial crisis but closed when QE began in 2008. These repo and reverse repo SRFs allow the Fed to intervene in real-time if the repo market threatens to falter. So the above 2019 situation is not likely to happen again.

So what are the minimum reserves under the "broad reserve regime" combined with the SRF safety feature?

It could be less than $1.6 trillion due to the safety feature. But let's stick with $1.6 trillion as the minimum for now.

 

Reverse repurchase agreements

Under these contracts, the Fed takes cash and delivers collateral (Treasury securities). They are a liability because it is money that the Fed owes to its counterparties. The Fed pays 2.3% interest on this cash.

The Fed offers two sets of reverse repurchase agreements, and the two combined total $2.53 trillion:

  • "Official foreign and international accounts," where foreign central banks deposit their cash in dollars: $277 billion.
  • "Other," which are the "overnight PVPs" mostly with Treasury money market funds: $2.25 trillion.

Total RRPs began to increase in April 2021, but since June 2022 have been more or less stable in the $2.5 trillion range.

Overnight RRPs, currently $2.25 trillion, is cash from Treasury money market funds.

Early last year, Treasury money market funds were flooded with cash. Normally they would buy Treasury securities with short maturities, but demand was so high that in the short term, yields fell to 0% and briefly below 0%. A negative yield is a problem for money market funds, where the value of a unit could fall below $1, which could trigger a run on the fund, which could shoot up from there, which is why the Fed started offering RRPs and then started paying interest on them.

And now there is another reason for the rise in RRPs: the Treasury money market funds have started transferring the short-term cash they need to have available to RRPs, from their bank accounts, because the Fed pays higher interest on that cash. In addition, RRPs offer essentially zero credit risk, which large bank account balances do not.

What this means for the Fed's balance sheet: a shift from reserves to RRPs and this could explain why reserves fell $1 trillion in the last 8 months as RRPs soared.

 

How low can RRPs go?

In theory, they can fall to near zero as liquidity is squeezed out of the system through QT. There is no reason for the Fed to maintain a minimum RRP balance. This is demand-driven, and as other interest rates rise and liquidity disappears, RRPs could fall to very-low levels within four years. So, for our theoretical minimum, let's say it's close to $0.

 

Paper dollars: after a peak (maximum), demand has stagnated.

The currency in circulation, the paper dollars in your pocket, also known as Federal Reserve bills, are based on demand through the U.S. banking system. If customers demand paper dollars at the ATM or over the counter, the bank should have enough on hand. In other countries, foreign banks have relationships with U.S. banks to provide paper dollars to their customers.

U.S. banks obtain those paper dollars from the Federal Reserve in exchange for collateral, such as Treasury securities. In other words, as the demand for paper dollars increases, banks must obtain more paper dollars from the Fed and, to obtain them, they must deposit more collateral with the Fed. As the liability of currency in circulation increases, collateral, such as Treasury securities, also increases the assets on the Fed's balance sheet.

Before QE, currency in circulation was the main driver of the increase in assets on the Fed's balance sheet. And demand has been huge, but not for payment purposes.

Paper dollars are hidden under mattresses, in vaults, and in suitcases around the world. When there is a crisis, or a potential crisis, like Y2K, in the US, people stock up on paper dollars.

Currency in circulation, after rising during the pandemic, began to stabilize in early July and is now down a bit, to $2.28 trillion:

Do you remember Y2K? Where nothing happened. But everyone stocked up on paper dollars, and demand skyrocketed, and after the fiasco, the extra money went back to the Fed through the banks:

The bankruptcy of Lehman Brothers in September 2008 sent people to ATMs, withdrawing cash just in case. By the end of 2009, this was beginning to normalize again:

 

 

During the pandemic, there was a huge demand for cash. Between the end of February 2020 and December 2021, cash in circulation soared by 25%. There is a chance that some of this could be resolved:

 

Whenever there is an increase in currency in circulation, the Fed's assets increase by the amount of collateral banks post to obtain paper dollars.

 

The Treasury's General Account

The government's checking account is at the Federal Reserve Bank of New York. The amount the government has on deposit there is a liability to the Fed because it is money the Fed owes the government.

The level of deposits has swung wildly, driven by protracted debt ceiling fights when the government nearly ran out of cash before Congress relented and by the government's super massive debt issuance early in the pandemic to pay for stimulus programs. That debt issuance generated a large amount of cash that took a while to retire.

And now there is a new element: rampant inflation, which increases outlays and revenues. Over the years, as larger amounts flow through the current account, the average balance is likely to rise to accommodate the larger flows.

As of the Fed's balance sheet released on September 1, the government had $670 billion on deposit at the Fed. The green line represents the pre-pandemic trend of the increase in the average account balance. A turn was made on the green line, starting in early 2021, when out-of-control inflation began to show the long-term trend with much higher inflation.

It can be estimated that the average balance could be around $800 billion.

Floor for liabilities: $5.2 trillion

In summary, the floor for the Fed's total liabilities would be $5.2 trillion:

Reserves: $1.6 trillion
PVP: about $0
Currency in Circulation: $2.7 trillion
TGA: $800 billion
Other Liabilities beyond the Big Four: $50 billion
So, according to these estimates, the floor for total assets on the Fed's balance sheet would be about $5.2 trillion, below which the Fed could not go. At its peak, the Fed had $8.97 trillion in assets. So AXL Capital Management says based on the above calculations that the Fed could do a maximum QT of about $3.8 trillion.

This would be a huge reduction in liquidity and would lower asset prices (stock market and gold to be more specific). This is why QT is loathed by investors when its effects become apparent.

But wait... uncontrolled inflation can change the behavior of the paper dollar.

If inflation continues to rise, paper dollar holders may tire of being attacked and could convert those paper dollars into interest-paying assets. If that happens, there could be a significant decline in currency in circulation and thus collateral, which would further reduce the Fed's assets and provide a lower floor.

Decades of relatively low inflation minimized the cost of holding paper dollars, but now that cost is skyrocketing. We may already be seeing some of that because in recent months, currency in circulation has actually plunged. If this is a trend in the making, many of these Fed notes could come back to the Fed, further reducing both sides of the balance sheet and lowering the floor below which the Fed cannot go.

 

Summary

In this Research we have focused on analyzing the future behavior of the Fed's balance sheet, based on historical and current information to determine a baseline for the same and consequent end of QT, as we believe that this, along with the aggressive rate hikes being carried out by the Fed, are the two monetary policy tools that can have the highest negative impact on the U.S. stock market and therefore, the rest of the world.

In our next article (short-insight), the AXL Capital Management team will focus on discussing the other monetary policy tool (interest rates), taking advantage of the FOMC meeting last Wednesday, September 21, 2022.

With this, we will be able to draw better conclusions about the future of the stock market.

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