Adding T-bills, shedding MBS, Treasury note & bond balances on ice, SRF unused.

By Wolf Richter for WOLF STREET.

Total assets on the Fed’s weekly balance sheet, released today, rose by $23 billion in February, to $6.63 trillion. Since the beginning of the “Reserve Management Purchases” (RMPs) in early December, total assets have risen by $93 billion.

The $2.4 trillion in QT ended in November. At the December FOMC meeting, the Fed announced it would let the balance sheet grow by buying roughly $40 billion a month in T-bills until mid-April (Tax Day), after which the RMPs would be “significantly reduced.”

The Fed is also replacing its MBS that run off the balance sheet with T-bills (Treasury securities with terms of 1 year or less). By replacing MBS with T-bills, the Fed is replacing long-term securities with short-term securities.

Powell is the architect of the Fed’s “ample reserves” regime, where the goal is to have enough reserves (bank cash on deposit at the Fed) to prevent overnight interest rates from deviating more than just a hair from the Fed’s stated policy rates.

The newly nominated Fed chair, Kevin Warsh, has come out strongly against the Fed’s bloated balance sheet, quit the Fed’s Board of Governors over QE 2 in 2011, and has stuck to his guns through the nomination process, and has still gotten nominated. So the balance sheet’s future may look different than what Powell envisioned with his “ample reserves regime.”

Before QE, before 2008, the Fed had a “scarce reserves regime,” where banks borrowed from each other in the unsecured Federal Funds Market and from the Fed via repos, on a daily basis as needed to meet their daily liquidity requirements. By borrowing unsecured from each other, banks became a huge conduit for contagion to spread from bank to bank during the Financial Crisis. Interbank lending has by now essentially died down, except for a bizarre arbitrage trade between the Federal Home Loan Banks (FHLBs) and foreign banks.

Before QE, before 2008, the Fed’s balance sheet always grew, usually more or less in parallel with the economy and inflation. Over those years from the beginning of 2003 to August 2007, the balance sheet grew by 22%:

Mortgage-Backed Securities (MBS) declined by $13 billion in February, to $2.01 trillion, down by $730 billion (27%) from the peak.

MBS come off the balance sheet primarily via pass-through principal payments that MBS holders receive as mortgages are paid off and as mortgage payments are made. The Fed holds mostly MBS that are backed by mortgages that were originated during the low-interest-rate years, and those below-4% mortgages are only slowly getting paid off (the lock-in effect for homeowners).

Due to the housing market’s literally frozen status in January and February, fewer homes were sold, and fewer mortgages were paid off, and the passthrough principal payments of $13 billion were below the normal range of $15-17 billion.

The Fed holds only “agency” MBS that are guaranteed by the government (issued by Fannie Mae, Freddie Mac, Ginnie Mae), where the taxpayer would eat the losses when borrowers default on mortgages.

T-bills rose by $55 billion in February to $344 billion: $15 billion to replace MBS and $40 billion in RMPs.

Treasury notes and bonds are essentially on ice, and there was no change in February in the balance of $3.60 trillion.

The Fed currently replaces every Treasury note (2-10 years) and every Treasury bond (20 and 30 years) that matures with securities of the same tenor, so a maturing 10-year note with a new 10-year note that the Fed buys at the Treasury auction. So the balance remains flat.

Bank liquidity facilities:

• Standing Repo Facility (SRF): $0 billion, see below.
• Central Bank Liquidity Swaps: $0 billion
• Discount Window: roughly unchanged, $4.7 billion.

The SRF: $0. Over 40 approved counterparties (big banks or broker-dealers) can borrow at the SRF with overnight repurchase agreements, where the Fed gets the collateral and the banks get the cash. The repurchase agreement unwinds the next business day, and the Fed gets its cash back, and the banks get their collateral back. Since the December FOMC meeting, the Fed has been charging banks 3.75% in interest on these repos.

At the end of October, turmoil broke out in the repo market as month-end liquidity pressures met with the government shutdown, which had caused the government’s checking account at the Fed, the TGA, to absorb $200 billion in cash that wasn’t getting disbursed, and repo market yields spiked.

Banks stepped in and borrowed at the SRF and lent to the repo market to profit from the spread. On October 31, the SRF balance hit $50 billion. Then the month-end pressures faded; the SRF had done its job.

But the Fed expressed disappointment with the banks that they’d used the SRF too little too late, which had allowed repo market rates to surge too far above the upper end of the Fed’s policy rates.

At the end of November, the month-end liquidity pressures pushed up repo rates again, but not that much, and banks used the SRF, but not that much, with the balance peaking at $26 billion on December 1.

On December 31, amid the yearend liquidity pressures, the SRF balance spiked to $75 billion, then plunged back to zero over the next two business days.

The biggest liquidity stresses would come around Tax Day when massive amounts of liquidity flow out of the financial system into the government’s checking account at the Fed (the Treasury General Account), thereby moving that liquidity from the financial system to the Fed’s balance sheet, where it vanishes.

The RMPs are designed to build up enough reserves by Tax Day to let them handle most of those liquidity flows, with the SRF making up the difference as needed.

Reserves and ON RRPs represent instantly available liquidity in the financial system. They’re liabilities on the Fed’s balance sheet, not assets.

Banks have cash on deposit in their reserve accounts at the Fed. They pay each other through their reserve accounts, via the Fed’s central payment system. Every financial transaction flows through the reserve accounts. Banks also keep their excess cash in their reserve accounts. The Fed pays banks currently 3.65% in interest on their reserve balances.

The purpose of the RMPs is to increase the level of these reserves.

Money market funds put their excess cash on deposit at the Fed via Overnight Reverse Repurchase Agreements (ON RRPs). The Fed pays 3.50% in interest on these repo balances.

Reserve balances have risen by $83 billion since RMPs started in December, to $3.02 trillion.

ON RRPs are down to $0 billion. Back in mid-2022 through March 2023, they exceeded $2 trillion.

The chart shows that QT has wrung nearly $3 trillion in liquidity out of the financial system since the peak at the end of QE, but that liquidity remains high, or “ample,” as Powell would say. And Warsh can do some careful trimming here:

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