It’s hard to overstate how free and unlimited central bank liquidity has rewired the financial system. As central bankers claw their way out of the monetary rabbit hole they have fallen into, the damage to traditional wallets is likely to be extensive.
This tightening of monetary policy is happening because inflation has returned – with a vengeance. Central banks are raising short-term interest rates at a brisk pace. But there is an additional danger for markets prone to liquidation: quantitative tightening (QT).
Major central banks are now reducing their balance sheets – the US Federal Reserve (the Fed) by $95 billion a month starting in September. Private investors will have to absorb far more duration risk than they have recently, with the net result being higher long-term interest rates.
In markets rooted in the belief that interest rates will be “low for a long time”, it is no surprise that risky assets have been hit. But there is another reason: by shrinking its balance sheet, the Fed’s QT will drain liquidity from the banking system.
It may not matter initially: commercial bank reserves at the Fed are still north of $3 trillion. But they are already falling rapidly and could soon reach a biting point where dealerships’ role as a liquidity provider will be compromised. We hit such a tipping point in the second half of 2018. At the time, inflationary dangers were absent and the Fed could abruptly reverse course. This time around, the Fed has no choice but to keep its foot on the brakes.
No one knows where that biting point really is, not even the Fed. Four years ago, he underestimated the considerably higher level of reserves banks wanted to operate with, given the much stricter regulatory environment. Today, the Fed is still in the dark.
Worse still, another force is acting to drain bank liquidity – ironically, a creation of the Fed itself. The Reverse Repurchase Facility (RRP) allows intermediaries to place funds overnight with the Fed, backed by US Treasury guarantees. This otherwise innocuous corner of the payments architecture is important because it provides access to the Fed’s balance sheet to non-banks, particularly the $4.5 trillion money market mutual fund (MMMF) industry. More than $2.2 trillion in funds are now deposited with the Fed each evening via the RRP, the vast majority of which comes from the MMMF sector.
The use of RRP by MMMFs drains reserves from the banking system, dollar for dollar. In short, it gets us to the liquidity bite point faster than QT alone. How much faster is uncertain, but demand for RRP access is increasing (see graph) – and should continue to do so. When interest rates rise, cash investors turn to MMMFs because they raise rates faster than banks, making them more attractive. And as funds invested in MMMFs increase, so will the desire to place those funds in the Fed’s RRP.
This dynamic could be very important over the next six to twelve months. In 2018, we learned that a shortage of bank reserves can trigger financial dislocation. In 2022-23, given the Fed’s stubborn pursuit of monetary tightening, we may find out just how damaging and pervasive such dislocation can be in markets that have been inflated by more than a decade of monetary largesse. As Warren Buffet observed, it is only when the tide goes out that you find out who is swimming naked. With the imminent depletion of liquidity, many assets – and indeed investors – could soon be exposed.
Sources: US Federal Reserve
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