A few days ago, I mentioned that RRP drain had likely started the clock on the end of balance sheet rundown.
In the wake of the debt ceiling deal six months ago, sundry liquidity bear cases made the rounds, all of which were predicated at least in part on the notion that Treasury’s cash rebuild might not go as planned, that RRP transformation wouldn’t be “one-for-one” (so to speak) and that with Fed QT running in the background, the potential for “friction” (if you will) was high.
Those bear cases didn’t pan out. Another bear case did. The long-end of the US Treasury curve succumbed to intense bouts of volatility as the market repriced the term premium. That drama was too much for equities, which sold off for three straight months. But as BMO’s Ian Lyngen and Ben Jeffery wrote, in a note dated November 22, “one aspect of the market that stayed nothing if not sanguine has been funding markets.”
As discussed in the latest Weekly, RRP balances were just $865.9 billion on November 24, the lowest since July of 2021.
In short, the $1.3 trillion drain from the facility since early-June meant “the money market space has continued to benefit from the residual liquidity that continues to keep overnight rates contained,” as Lyngen and Jeffery went on to write.
In “Here’s How Fed Balance Sheet Runoff Ends” I talked a bit about key levels associated with bank reserves. RRP transformation has mitigated reserve drain. We can debate the thresholds for “abundant” and “ample,” but we’re nowhere near scarcity. That could change, though. As we saw in September 2019, “scarcity” can be an “objects in mirror are closer than they appear” sort of deal.
“Thus far, this process has played out without triggering a meaningful drawdown in bank reserves, but looking forward, as RRP balances drop, there will eventually come the transition from abundant to ample and a more traditional supply/demand dynamic in the front-end,” BMO’s US rates team wrote, in the same note cited above.
The figure above shows that when things “snapped” in September of 2019, the “pain point,” as Lyngen and Jeffery put it, was 6.4% of GDP.
Ostensibly, that gives Jerome Powell a lot of runway. Reserves are 11.5% of GDP now. So, RRP drain can continue, and so can QT for the foreseeable future.
However (and to reiterate), it’s not possible to know, definitively, what the scarcity threshold is. There are any number of factors which determine when reserves become “scarce” in this context, not all of which are strictly quantitative (some of the relevant considerations could be described as “pseudo-qualitative”).
One way or another, this discussion is set to become more topical in the months ahead, with the sense of urgency increasing commensurate with the pace of incremental RRP decline.
So far, “the risk of reserve scarcity similar to September 2019 [has been] low on the Fed’s list of worries [but] with bill issuance set to stay lofty as a share of overall debt outstanding and QT continuing to shrink SOMA, the state of the funding market is a space to watch,” Lyngen wrote. “The risk remains that the removal of liquidity doesn’t play out in linear fashion… necessitat[ing] a more dovish shift in policy sooner than Powell would prefer.”
