The End Is in Sight for Quantitative Tightening (January 30, 2024)

Lower Treasury borrowing estimates have dashed QT wind-down hopes. But it probably won’t matter. 

By Lisa Beilfuss

A lower-than-expected borrowing estimate from the U.S. Treasury has pushed out expectations for when the Federal Reserve will taper and complete its balance-sheet shrinkage. But the connection may not be as straightforward as many assume, meaning investors may be in for a positive surprise.

The Treasury on Monday said it plans to borrow $760 billion in the first quarter, lower than its $815 billion estimate last fall and down from $776 billion in the fourth quarter of 2023. For the second quarter, Treasury estimates $202 billion in issuance, down from $278 in last year’s second quarter. (Second-quarter borrowing is usually lower because that is when individual income tax returns are due).  

As Bleakley Capital’s Peter Boockvar notes, Treasury’s quarterly refunding announcement is now market-moving news because of enormous debts and deficits. But there is another reason for increased Treasury refunding attention: Many strategists say less borrowing translates to a longer stretch of quantitative tightening (QT), or the reversal of pandemic-era bond purchases known as quantitative easing (QE). 

The connection between Treasury borrowing and QT is mostly discussed via the Fed’s overnight reverse repurchase facility, or RRP. The central bank uses the RRP to provide a floor on the rates at which money market funds, primary dealers and banks are willing to lend to counterparties. After a period of relatively stable balances during the first half of 2023, the RRP has quickly dropped to roughly $600 billion from over $2.2 trillion in December 2022. 

The RRP decline is a function of Treasury borrowing and is thus partly by design. When the Treasury issued $1.6 trillion in net bills last year, it pushed money market rates above the RRP offering rate, prompting money market funds out of the RRP and into Treasuries.

At the current rate of rundown, the RRP will be near zero by June, estimates Joe LaVorgna, chief economist at SMBC Nikko Securities. Some predict sooner. 

Market participants view the level of funds invested in the RRP as an indication of banking-system stress, where a bigger balance suggests less stress. LaVorgna explains it this way: Because the RRP is a liability on the Fed’s balance sheet, bank reserves are created when the RRP declines. That adds liquidity to the financial system, negating QT and lifting risk assets. And so once the RRP bottoms, the negative effects from QT resurface as its effects are more pronounced in financial markets. 

Some officials have expressed concern about the fast drop in the RRP. “In my view, we should slow the pace of runoff as overnight RRP balances approach a low level,” Dallas Fed President Lori Logan said in a recent speech, adding that doing so could reduce the likelihood the Fed would have to stop QT prematurely. 

While connecting the RRP level to the end of QT makes sense, the consensus analysis may be too simple. In other words, relatively lower Treasury issuance and a related slowdown in the RRP decline likely won’t preclude the Fed from winding down QT and finishing its balance-sheet shrinkage sooner than later. 

First, consider this point from Craig Shapiro, macro advisor at LaDuc Trading. The Treasury often gets its initial borrowing estimates wrong, so there was little risk for Treasury Secretary Janet Yellen to announce a low borrowing number for the second quarter. “They were wildly wrong last year. She can always issue more bills if necessary later in the quarter if they are light on revenue,” Shapiro says.  

Early data support Shapiro’s point. Overall federal tax deposits are up just 0.1% this month from a year earlier and have slowed to 5.6% fiscal year-over-year, down from a 7.8% pace at the end of December, notes Richard Farr, chief market strategist at Merion Capital. Moreover, income and employment withholdings taxes in January are down 0.8% fiscal year-over-year.

Second, markets may be misinterpreting the RRP and missing the bigger picture as it relates to Fed policy. Steven Ricchiuto, U.S. chief economist at Mizuho Securities, says he isn’t convinced that a diminishing level of RRP reflects increased stress in the financial system. 

Instead, he says the RRP level reflects investor preferences for investing cash balances. Ricchiuto emphasizes bank reserves (note that the RRP yields roughly 5.3% and bank reserves earn about 10 basis points more), which must be large enough relative to the level of economic activity in order to support bank lending. Right now bank reserves are about 15% of bank assets and 12.5% of GDP, well off highs of 19.5% and 17.5%, respectively, he says. What is more, both metrics have declined to levels seen in 2018-2019–when troubles in money markets forced the Fed to abruptly end QT.  

“Our longstanding call for the Fed to begin tapering QT early this year reflects our calculation that the maximum the balance sheet can be trimmed is $2 trillion, given the expansion in the economy in the wake of the fiscal stimulus still being provided,” says Ricchiuto. His estimate is within sight. The balance sheet currently stands at $7.68 trillion, down from a peak of $9 trillion and compared with about $4 trillion leading up to the pandemic.  

For all the focus on the liquidity minutiae, there is a third point that is as salient as it is simple. “The Fed doesnt know how QT works,” says Joseph Wang, a former Fed trader and CIO at Monetary Macro. “We could have the Treasury market become disorderly. That could make the Fed change its plans.” All of this is not to mention the fact that a soft landing, or the perception of one, is at stake and an election is approaching. 

For investors, QT was always the more interesting side of the Fed’s tightening campaign, even if Fed officials and news media have focused almost exclusively on interest rates. Less QT tends to be good for risk assets. The notion of data dependence is illusory; if the government wants to curtail QT, it will do so.