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Investing in the long-duration trade is where my focus lies when it comes to real money. It's essential to keep an eye on potential strains in the money market. About a month ago, I suggested that the Federal Reserve's quantitative tightening (QT) program might extend well into 2024. This was based on the belief that the current level of reserves in the system was more than sufficient for the balance-sheet runoff to continue indefinitely. Reserves, currently over 83 trillion (originally 53.5 trillion), have been on a slight upward trend since the end of March.
However, there's a prevailing view on Wall Street that the Fed might have to cut or scale back QT in early 2024. This speculation is rooted in concerns that liquidity in certain parts of the Treasury market might tighten, forcing the Fed to intervene. Recent brief but significant funding strains served as a reminder that even the world's most liquid and deep market can face challenges that might abruptly end QT.
In September 2019, in response to a repo market seize-up, the Fed had to step in and provide liquidity. It suspended QT, implementing special repurchase operations and lowering administered rates. The Fed ultimately pledged to purchase $60 billion in Treasury bills through the second quarter of 2020, effectively putting QT on hold.
It's important to note that bank reserves, which had dropped to just over 9% of GDP during the repo market stresses, are now at around 11%. However, the timing of the transition from "abundant reserves" to an "ample" regime is uncertain. In a recent survey, over one-third of financial officers expressed a preference for holding additional reserves above their lowest comfortable level, anticipating potential scarcity into 2024.
The drainage from the Fed's Reverse Repo facility (RRP) is happening rapidly, with usage dropping from about $2.2 trillion in May to $683 billion recently. Despite this decline, there hasn't been a corresponding decrease in bank reserves. Money market funds (MMFs) purchasing T-bills contribute to the Treasury's general account (TGA) increase at the Fed.
Anticipating a significant decrease in the RRP facility to half a trillion dollars early next year, and almost complete depletion by the end of 2022, we might witness a meaningful decline in bank reserves. Chair Powell acknowledged the potential for the RRP drain to end, leading to a decrease in reserves.
While my view remains, that QT will continue into 2024, the developments in the RRP and their impact on reserve balances warrant close attention. Checking in on real money investors' behaviour in the Treasury market as we approach year-end, our data indicates a continued preference for the long duration trade. Investors are rotating out of the shorter end of the coupon curve into longer-dated securities, as depicted in the chart. The long duration trade seems to persist, particularly in the 10y+ and 7-10y buckets.
However, caution is advised for the back end of the curve. Despite the policy-driven incentive to go long duration, concerns about supply into 2024 might eventually counteract this trend. For now, I remain cautious and believe that the supply issue could become more prominent in the market's focus in 2024.
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