QT continues. Liquidity is “more than ample.” Money market spreads widening briefly is OK. Selling MBS and shifting from longer-term Treasuries to T-bills is on the table. 

By Wolf Richter for WOLF STREET.

Lorie Logan, president of the Dallas Fed, is a leading voice on the technicalities of the Fed’s balance sheet and QT. Prior to the current job, she was an executive VP of the New York Fed, managing the System Open Market Account (SOMA) which handles the operations of the Fed’s securities portfolio. Her hawkish commentary on Monday about the future of QT, the balance sheet composition, and liquidity contributed to roiling the bond market, with longer-term yields and mortgage rates spiking to multi-month highs.

She was the one who said in January 2024 that QT would eventually drain Overnight Reverse Repos (ON RRPs) to near zero, from over $2.3 trillion at the peak, which was a shock for lots of folks because it implied far bigger QT than they’d feared.

ON RRPs are a way for money market funds and other counterparties to deposit excess cash at the Fed and get paid interest on it. She said when they “eventually approach zero,” it would be time to slow the pace of QT. In March, with ON RRP balances plunging apparently straight toward zero, Logan became more detailed and explained why QT should slow when ON RRPs approach zero: “Moving more slowly can reduce the risk of an accident that would require us to stop too soon,” she said.

In May, with ON RRPs down by about $2 trillion and still plunging, the FOMC announced that it would slow QT starting in June. But then, ON RRP stopped their descent for a while and then slowly zigzagged lower, and are currently at $238 billion (see chart of ON RRPs below this article in the comments).

Reserves (cash that banks put on deposit at the Fed and get paid interest on) have started to finally drop a little. Bringing reserves down from “abundant” to merely “ample” has been the purpose of QT all along. But after two years and nearly $2 trillion of QT, reserves are still considered “abundant.”

On Monday, she gave another speech on the balance sheet, titled “Normalizing the FOMC’s monetary policy tools” – at the Securities Industry and Financial Markets Association annual meeting. Here are the salient points on the future of QT and the balance sheet.

QT will continue despite rate cuts. QT and “gradually lowering the policy rate toward a more normal or neutral level” are both part of monetary policy normalization, she said, and added:

“Normalizing the fed funds rate means bringing it down from the elevated levels that were needed to restore price stability and returning to a level that will be consistent with sustaining maximum employment and price stability over time.”

“Normalizing our balance sheet means bringing our asset holdings down from the elevated quantity that was necessary to support the economy during the pandemic and returning to a balance sheet size that will be consistent with implementing monetary policy efficiently and effectively.”

Liquidity is still “more than ample.” The purpose of QT is to reduce liquidity from “abundant” to “ample.” Since no one knows where “abundant” ends and “ample” begins, Logan is looking at clues that money markets are giving off.

“One sign liquidity remains in abundant supply, and not merely ample, is that money market rates continue to generally run well below IORB [the interest rate the Fed pays the banks on reserves, currently 4.9%]. The tri-party general collateral rate (TGCR) on repos secured by Treasury securities has been averaging 8 basis points below IORB [currently at 4.82%]. Because reserves and Treasury repos are both essentially risk-free overnight assets – and reserves are, if anything, more liquid – the spread of IORB over TGCR indicates reserves remain in relatively excess supply compared with other liquid assets.”

“Unsecured funding conditions [in the federal funds market] also continue to reflect abundant liquidity. The effective federal funds rate has been running 7 basis points below IORB and remains insensitive to short-term fluctuations in reserve levels.”

“And the continuing substantial balances in the Fed’s overnight reverse repo (ON RRP) facility provide another sign that liquidity remains more than ample.”

Get used to money market spreads widening briefly.  The Fed is going to tolerate these brief events, especially at the end of the quarter because they’re “price signals” that markets need in order to distribute liquidity. She said:

“For example, on September 30 and October 1, the spread between SOFR and TGCR widened by 7 to 12 basis points. This widening reportedly resulted from limited balance sheet availability at dealers that intermediate between the triparty and centrally cleared market segments.”

“Such temporary rate pressures can be price signals that help market participants redistribute liquidity to the places where it’s needed most. And from a policy perspective, I think it’s important to tolerate normal, modest, temporary pressures of this type so we can get to an efficient balance sheet size.”

ON RRPs should essentially vanish from the balance sheet. She said it would be “appropriate in the long run to operate with only negligible balances in the ON RRP facility.”

And if ON RRPs refuse to vanish… “I anticipate the remaining balances will move out of the facility as repo rates rise closer to IORB, but if they do not, reducing the ON RRP interest rate [currently 4.8%] could incentivize participants to return funds to private markets” instead of leaving them parked at the Fed.

Get rid of MBS, maybe sell them to speed up the process. “We intend to hold primarily Treasury securities in the long run,” Logan said, citing what the Fed has said for years. But getting rid of MBS has been slow going. MBS come off the balance sheet mostly via passthrough principal payments when the underlying mortgages are paid off or are paid down. But much higher mortgage rates have caused mortgage refis to collapse and sales of mortgaged homes to plunge, and passthrough principal payments have slowed to a trickle. She said:

“As indicated in the minutes of the May 2022 FOMC meeting, a number of FOMC participants have suggested it could be appropriate at some point to sell MBS to move the mix of assets closer to our goal. But that’s not a near-term issue in my view.” So maybe medium-term?

Shifting Treasury holdings toward shorter maturities. Logan expects the balance sheet composition to shift toward shorter maturities, where the Fed would replace maturing long-term securities with T-bills and shorter-term securities. She said the “two most plausible options in the long run” for this shift are:

Either “hold a roughly neutral Treasury portfolio, meaning one with a maturity composition similar to that of the Treasury universe.”

The Fed is overloaded with longer-term maturities, and only 4.5% ($195 billion) of its Treasuries are T-bills. But 22% of marketable Treasury securities outstanding are T-bills. To get to a neutral composition with T-bills at 22% of its Treasury holdings, the Fed would have to replace a lot of longer maturities with T-bills.

Or “tilt toward shorter maturities” which “would allow more flexibility.” So even more T-bills would replace even more longer-term securities. That’s how the Fed used to do it before 2008.

The flexibility a “tilt toward shorter maturities” provides would matter if the Fed cut interest rates to 0% (the effective lower bound), and the economy still needs more help with lower long-term rates. In that case, instead of restarting QE, the Fed could let T-bills run off the balance sheet and buy longer maturities, which would keep the balance sheet size the same but would push down longer-term yields.

“Either way, the System Open Market Account portfolio is significantly underweight Treasury bills, and its weighted average maturity remains significantly longer than that of marketable debt outstanding. The tradeoffs around how to move toward a more neutral portfolio are complex and will require thoughtful policy deliberations,” she said.

The Fed’s role as liquidity provider to banks. As QT removes more liquidity, and as reserves decline toward “ample,” the Fed’s classic role of short-term liquidity provider to banks is expected to make a comeback. Logan briefly discussed two basic liquidity tools, the Standing Repo Facility (SRF) and the Discount Window.

The Standing Repo Facility was revived in July 2021, a year before QT started, after the Fed had shut it down in 2009 because the massive amount of new liquidity from QE had made it useless. Before 2009, banks used it on a daily basis to manage their liquidity. And the Fed used the SRF to deal with market problems before QE. For example, on 9-11, when markets were shut down for days, the SRF was the balance sheet tool the Fed used to calm the waters – and not QE.

But use of the SRF is not automatic. Banks have to get set up and approved. Logan exhorted banks “to consider the potential benefits of establishing access to the SRF.”

And there was a little bit of use at the end of the quarter, when lots of liquidity flows all over the place. On September 30, banks borrowed $2.6 billion from the Fed via overnight repos that matured on October 1. It was minuscule, and it was just for one day, but it was the first draw on the SRF since its revival. Logan referred to it:

“I was pleased to see the SRF drawn on over the quarter-end turn as market participants worked through frictions in the redistribution of liquidity.”

The discount window. Logan exhorted banks: “Every bank in the United States should be operationally ready to access the discount window. That means completing the legal documents, making collateral arrangements and testing the plumbing…. Take out and repay small-dollar test loans. And practice moving collateral between the window and other collateralized funding sources, in case a scenario arises where you can’t get the funding you want from those sources. The window is an important tool for healthy banks to meet their liquidity needs, but it works only when banks are ready to use it.”

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