It’s All Over Now - Quantitative Tightening

The Federal Open Market Committee (FOMC) dedicated a significant portion of the year 2023 to allowing their balance sheet reduction plan to operate seamlessly, with minimal discourse on the ultimate strategy for its conclusion. However, the issue gained increased attention during the latest meeting in mid-December, wherein "several" Committee members expressed their endorsement for initiating discussions on when and how to decelerate the pace of balance sheet runoff.

Considering this development, it is now anticipated that the FOMC will formulate the framework of a timeline to diminish the reduction in the balance sheet during the late January meeting, with the details communicated to the public through the mid-February minutes of that meeting. The formal approval of this plan is expected to take place at the mid-March meeting, and implementation is slated to commence in April.

My projections indicate a reduction in the monthly cap on the runoff of Treasury securities to $30 billion (down from $60 billion per month), while I foresee no alteration to the $35 billion per month cap on mortgages. An alternative scenario could involve gradual reductions to $40 billion per month and eventually settling at $20 billion per month. In either case, I anticipate the continuation of balance sheet reduction, even if the Federal Reserve is lowering rates, provided these rate cuts are not in response to imminent recession concerns. My practical assessment suggests that a funds rate below 3% would be sufficient to halt balance sheet reduction.

The 2022 annual System Open Market Account (SOMA) report's projections indicate that the process will persist until the Federal Reserve determines that the reduction in its assets, and the corresponding decrease in liquidity provided to the financial system, has reached an acceptable level for Reserves to approach their lowest comfortable level (LCLoR). Moreover, the significance of maintaining a minimum Reverse Repurchase Agreement (RRP) balance has gained prominence among FOMC members. I foresee the Quantitative Tightening (QT) concluding at the end of November, with ON RRP balances still substantial enough to facilitate the smooth functioning of money markets, even as reserves remain somewhat above most estimates of LCLoR.

Once this milestone is achieved, I anticipate the Federal Reserve will permit mortgages to continue rolling off its balance sheet, with the proceeds reinvested across the yield curve in Treasuries. This strategic shift is envisioned to contribute to the overall stability and efficiency of the financial markets.

What Does that Means to the Market, and How Will it Impact the Markets?

Anticipated changes in Quantitative Tightening (QT), deviating from both my prior expectations and the market consensus, are poised to have significant implications for the US fixed income markets. Notably, this adjustment is seemingly ahead of consensus expectations, as evidenced by the latest Survey of Primary Dealers conducted before the December FOMC meeting. According to the median dealer projection, QT is expected to conclude in 4Q24, with reserve balances at $3.125 trillion and ON RRP balances of $375 billion. In contrast, the Survey of Market Participants envisions a later conclusion in 2Q25.

If my revised forecast materializes, it will lead to a passive runoff of $420 billion in 2024, a notable reduction from my initial forecast of $720 billion. While this adjustment does not alter Treasury's financing needs, it does result in comparatively fewer Treasuries returning to private non-Fed hands. Consequently, I anticipate $300 billion less in net issuance than previously projected. Although one might intuitively expect a proportional reduction in coupon-bearing Treasuries, my analysis suggests a decrease in T-bill issuance, rather than coupon issuance, for the current year.

Examining Treasury's auction calendar for notes, bonds, and TIPS, I perceive these as stable components designed to finance the longer-term deficit outlook. In contrast, T-bills are seen as filling gaps for cyclical and seasonal swings in financing needs. Given this longer-term financing outlook, I posit that Treasury is unlikely to deviate from its current path, thereby resisting further increases to coupon auction sizes considering heightened financing needs in the coming years. Consequently, my updated forecast envisions $2.280 trillion in net privately held borrowing needs in 2024, $300 billion less than my initial projections, as net T-bill issuance moderates to $377 billion, down from the previous estimate of $675 billion.

While the Treasury runoff caps were halved in May 2019, the MBS caps remained at $20 billion. Upon the conclusion of QT, MBS paydowns up to $20 billion were reinvested in Treasuries, with any excess going back into MBS. Presently, the $35 billion MBS cap significantly exceeds the actual paydowns of $15-20 billion, making the likelihood of the Fed reinvesting paydowns exceeding $35 billion into MBS very low. The end state of this process is to reinvest all MBS paydowns, maintaining steady reserve balances. However, the Fed's objective is to transition to an all-Treasury balance sheet, making reinvesting into MBS counterproductive. I posit that the $35 billion cap can remain unchanged for now, with the announcement that as Treasury runoff concludes, MBS paydowns will be fully reinvested in Treasuries.

Recalling the Fed's 2019 practice of reinvesting mortgage paydowns into Treasuries, I project $15 billion in secondary market demand for Treasuries in 2024 and approximately $180 billion in 2025 under my revised QT forecast. While this would help address structural supply/demand imbalances in Treasury markets, it is not expected to materialize until later this year. Additionally, I acknowledge the question of why the Fed holds a securities portfolio longer in duration than the overall Treasury market. Although the Fed could opt to reinvest MBS paydowns into T-bills to align with the Treasury market's maturity profile, I consider the likelihood of such a shift low, given the simplicity of maintaining the status quo.

Considering the slower pace of QT, the Fed's balance sheet could stabilize from December onward, all else being equal, relieving one source of pressure on bank deposits. This potential increase in deposit growth suggests that banks may augment them.

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