The Fed's money drain is about to get real

The Federal Reserve's quantitative tightening (QT) programme has taken nearly $1 trillion of government and mortgage debt off its books without upsetting the financial plumbing. It went smoothly because the cash drained came out of the Fed's Overnight Reverse Repo (ON RRP) facility rather than out of commercial bank reserves. That buffer is running out fast.

How the drain works

QT began in June 2022 and reached full speed that September, with the Fed allowing up to $60 billion of Treasuries and $35 billion of mortgage-backed securities to mature each month without reinvesting the proceeds. When a Treasury held by the Fed matures, the government must borrow the money from private investors to repay it. Those investors pay with cash that sits either in bank deposits, which draws down bank reserves, or in money-market funds, which pull it from the reverse repo facility.

Which pool pays depends on relative rates. Money-market funds earn 5.30 per cent overnight at the reverse repo facility, and since the debt-ceiling deal in June the Treasury has issued a flood of bills yielding a little more. Funds have therefore moved hundreds of billions of dollars out of the Fed facility and into bills. That is why bank reserves have held up, and even risen, over the past year while the Fed's balance sheet shrank.

When reserves start to shrink

The RRP has fallen from over $2.5 trillion to roughly $700 billion and is on course to empty by the middle of the year. After that, every dollar of QT will come straight out of bank reserves. As reserves near what is known as the 'lowest comfortable level of reserves' (LCLOR), volatility will return to wholesale money markets, and the Fed will have to slow or stop shrinking its balance sheet.

Nobody knows exactly where that level lies, the Fed included. Demand for reserves differs across banks and has risen since 2008, as liquidity rules push large lenders to hold cash at the central bank and as supervisors have come to prefer it to other liquid assets. Reserves are also unevenly spread, so strain can appear at a handful of big dealer banks while the system as a whole still looks flush. The first sign of scarcity is usually a rise in private repo rates relative to the rate the Fed pays on reserves, currently 5.40 per cent.

The lesson of 2019

The last round of QT ended badly. The Fed shrank its balance sheet from 2017 and stopped in 2019, confident that reserves were still ample. In September of that year a corporate tax deadline and a large settlement of Treasury purchases drained cash on the same day, and overnight repo rates briefly spiked to around 10 per cent. The Fed had to inject cash through emergency repo operations and then buy Treasury bills to rebuild reserves, reversing part of what QT had achieved.

Officials have learned from that episode. In 2021 they created a standing repo facility, which lends to eligible banks and dealers against Treasuries at 5.50 per cent, the top of the policy range, and should cap spikes in repo rates. Its existence means a repeat of 2019 would probably be shorter and milder. It does not remove the underlying problem that a smaller supply of reserves makes rates more sensitive to swings in the Treasury's cash balance and to tax dates.

Other drains on the system

QT is not the only force at work. The Treasury's account at the Fed rises when tax receipts come in and falls when the government spends, and every increase pulls reserves out of the banking system. The mid-April tax date typically lifts that balance sharply, which will test the system just as the reverse repo cushion approaches its floor. The Bank Term Funding Program, set up after the failure of Silicon Valley Bank, is scheduled to stop making new loans in March, and repayments of those loans will also drain reserves.

Who feels the strain

The first to notice will be those who fund themselves overnight. Hedge funds running the Treasury basis trade, which relies on cheap repo borrowing to hold bonds against futures, would face higher and more volatile funding costs. Dealers holding large inventories of newly issued Treasuries would face the same squeeze. Smaller banks that depend on wholesale funding may have to pay more for deposits, and the spread between private repo rates and the Fed's administered rates would widen.

Investors in Treasuries could also feel it indirectly. If balance-sheet capacity at dealers tightens while the government continues to sell record amounts of debt, bond yields may have to rise to attract buyers. That would tighten financial conditions in a way the Fed did not intend.

The case against alarm

The strongest counterargument is that reserves remain far above the levels of 2019, and that the Fed is watching closely. Officials have said they intend to slow the pace of run-off as reserves approach ample levels rather than wait for trouble, and the standing repo facility gives them a safety valve. Some of the remaining $700 billion in the reverse repo facility may also prove sticky, since not every money fund can easily buy other assets.

That argument is fair, but it supports the column's conclusion rather than refuting it. If the Fed must slow QT to avoid strain, then the programme's painless phase is ending. The question is whether the Fed moves early enough to avoid a spike or only after one.

What to watch

The daily balance at the reverse repo facility is the most direct gauge; once it falls below a few hundred billion dollars, the cushion is nearly gone. The spread of the secured overnight financing rate above the rate on reserves, use of the standing repo facility and the size of the Treasury's cash account around tax dates will show when strain begins. Minutes and speeches from the Fed's committee in the coming months will reveal whether a slowdown in QT is being planned.

QT has been painless so far because it drained surplus RRP cash. By the summer it will be eating into bank reserves, and the first real strain in money markets will probably force the Fed to slow the runoff. The most likely sequence is a Fed announcement of a slower pace by mid-year, with a spike in repo rates around a tax date or quarter-end if officials move too late.