Odd Lots - Mark Cabana on the Fed, QT and Treasury Funding

Episode Date: January 31, 2024

It's a busy week for the bond market with a meeting of the Federal Reserve and the release of the US Treasury's quarterly refunding statement. While a lot of people have been focusing on when the Fed will cut benchmark interest rates, there's also an ongoing debate about how fast the central bank will shrink its balance sheet given last year's banking crisis and the recent drama in the repo market. In this episode, we speak with Mark Cabana, longtime rates strategist at Bank of America, about the big questions lurking behind the week's events. We talk about who will buy all the bonds the US is selling, what will happen to bank balance sheets as rates go down, and the impact of liquidity on the broader market.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLotts on Amazon Music. Hello and welcome to another episode of the OddLots podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. Joe, it's a busy week. It is a busy week. It sort of snuck up on me. You know, I knew it was Fed Week. Like, it's also Jobs Week. It's also, and I'm not even sure, like, the degree to which it matters, quarterly refunding week. sort of controversial. There was a lot going on. I got tipped off to the fact it was quarterly refunding week when everyone started talking about

deficits on Monday because we got the estimates of borrowing needs. That's the day suddenly everyone becomes really worried about the credit worthiness of the future United States of America. There's this theory that's going around. It's kind of controversial. I see it on Twitter sometimes that like this is like really important for markets, that like some mix of bills and bonds and how much really matters. I don't really know. I'm like, sort of like skeptical, but maybe there's something to that. But yet, a lot of moving parts right now. And of course, it is Fed Week. I don't think anyone expects a rate cut. But I think the expectation

is some sort of like maybe declaration of victory and which can then be used to set up the beginning of the cutting cycle. Well, it's interesting. You mentioned this theory about it having a potential impact on markets because, of course, the other thing that we expect the Fed to discuss this week is quantitative tightening. So the shrinking of the balance sheet. And I find this is the thing that gets people really riled up, the idea that, you know, stocks are up because of central bank liquidity. And once QT begins, it's all going to wash away and stocks are going to fall. Of course, we haven't seen that. But we're still waiting on a lot of additional info about the size, the shape, the speed of QT. And there's a lot of discussion over whether or not that could change.

And I should just say the meeting is tomorrow, but I don't think we're going to get a lot of detail on QT until the minutes actually come out in February. But the point is, there is loads to discuss. Yeah, totally. You know, and the one thing I'll say to on the balance sheet, I'll say two things. One is, for a long time, there was just the story. The Fed is pumping money into the markets, and as soon as the balance sheet starts to shrink, then that's going to be bad for risk assets. That, in my opinion, has now officially been disproven because the balance sheet has been shrinking basically since the money. middle of 2022, and stocks are at all-time highs. So that's been, that's over. That story, it's a thesis,

it's broken in my opinion. But what it means for banks, what it means for bank liquidity, how far they can shrink it before it creates problems, such as what we talked about, I think it was in 2019. This still matters quite a bit, and there's still interesting policy questions related to that. Absolutely. So who better to discuss all of these issues than Mark Cabana, rate strategist, over at Bank of America. Mark, thank you so much for coming on the show. Thanks for having me. We are longtime fans of your work, and it's kind of a treat for us that we could do this and release the episode on the day of the Fed meeting.

So we're recording it just the day before. So we're going to get all your thoughts on what's going on at the moment. But with your rates hat on, when you look at a week like this, when you have the QRA, you have jobs, you have the Fed. What are you most interested in? How are you weighing those different events? Sure. Well, thanks for having me. I'm also a big fan, so it's a real thrill to be here. Thank you.

So when we think about the rates outlook, we think that the expected path of the overnight rate is really the most important determinant of where rates go. Henceforth, the Fed is clearly the most important consideration for us this week. The payroll report and other data this week will inform that. And then still important, but perhaps secondary is the quarterly refunding from the Treasury, that supply announcement. though I agree with Joe, it has certainly been a focus in markets and probably much more so than the U.S. Treasury ever would have wanted. And that's really because they've surprised the market with the last two refundings. Oh, that's right, because wasn't it the August refunding announcement that kicked off that initial big surge in bond yields? And then it was the November one that kind of calmed things down?

So, yes, that's generally right. So they surprised by issuing more longer-dated coupons in the August refunding. They're then surprised by issuing fewer long-dated coupons in the November. of funding. And this was seen by the market as a factor that was a meaningful driver of where term premium was going. Now, I'm using air quotes as I say that. I know your listeners can't see the air quotes. But that is because term premium is sort of this catch-all unexplained factor, at least by certain Fed models. And I think one can view term premium with a healthy dose of skepticism. But nevertheless, the market perceived that those supply announcements were

big drivers of movements in term premium. By the way, for listeners, Tracy, that was a minute ago, I was drum rolling that sound because I always love when eminent guests confirm my biases. So nothing feels better than that. Setting aside market perception, in your own work, how important was the mix? So I guess there's two elements. There's just the total size of the borrowing each quarter, which is just a sort of economic reality that does. is just, you know, the gap between expenditures and the amount the government brings in in taxes. And then there is, okay, there's that mix that you described. How much is the Treasury going to issue at the long end versus the short end?

How important are these things to you? Setting aside what the market perceives or even what the market did, like when you see these announcements, like what are you looking for and how significant are them? So they certainly matter in terms of the relative mix of what Treasury is going to issue and how the private sector is going to take that down. But in terms of determining the overall direction of bond yields, we think that they are secondary. Important, but secondary. And what's more important is macroeconomic information, growth, inflation, jobs, et cetera, and how that's expected to impact the overall path of the Fed.

And what we saw really in the third quarter was, yes, you did get a larger than expected supply announcement from the Treasury, but you also had nominal GDP that was running at about 5% real, 9% nominal. That, we think, was the much larger driver of the movement in rates. Treasury supply announcement didn't help, but again, we think that the sharp upward moving rates was largely driven by better data. And conversely, in the fourth quarter, data moderated to some extent, the Fed turned more dovish. The Treasury surprised to the downside on supply, and that helped reverse some of the big move that we saw in late summer, early fall. So these supply announcements from Treasury, they do matter. They influence market perception. They certainly matter in terms of

how investors think about how much supply they're going to have to take down, how aggressive or not there to bid, how dealers manage the inventory on their balance sheets. But generally speaking, we do think it's a secondary factor, secondary to the incoming economic data that influences the expected path of policy. Mark, one of the other narratives that became kind of popular over the past year or so was this idea of who is going to buy the bonds. So, you know, with inflation rising, with the deficit growing, with a lot of natural buyers potentially stepping back, maybe some geopolitical concerns mixed in there, there was this narrative that, you know, that the traditional buying base of U.S. Treasury debt wouldn't be as large as it had been previously.

And yet, fast forward to the end of 2023, we had bond yields on the 10-year basically taking a round-trip. They're a little over 4% right now. But what do you think about that particular narrative? Yeah. So the number one question that we were getting over the course of 2023 is indeed who's going to buy the bonds. And it is a challenging question to answer when you are seeing inflation surprise to the upside, when the Fed is more hawkish than expected, and when bond yields are losing value. No surprise, investors don't really want to buy bonds when they're not holding their value. And as a result of that,

we did see that demand weakened from a whole host of traditional investors over the course of 2023, though they did come back to some extent towards the tail end. Now, when we think about who's going to buy the bonds, we really think about maybe four or five traditional buyer bases. Banks, pensions and insurers, overseas investors. asset managers, and then the Fed, and whether or not they are buying or selling at any particular point in time. They're obviously selling right now. For those buyer bases, we really saw a transformation in 2023 from those who really had stepped away from the market, largely in the first three quarters of the years, or some that had tried to buy tens at, let's say, 4%, and then got burned as tens rose

much more materially over the course of the year, and they had really taken a step back. But once we saw macroeconomic data, certainly inflation data, confirmed that the peak in inflation was over, that the Fed was not going to be hiking much more, likely next step would be cutting. We saw that demand returned quite meaningfully, and we've seen that from those traditional buyer bases. Banks, commercial banks, have stepped in to the market moderately. Pensions and insurers, we see they have generated the largest amount of stripping activity. A stripping, remember, is when you separate a long-term Treasury security into a principal component and an interest component. They like to buy the principal components because they're essentially

zero coupon bullets after they've been stripped. They have low dollar values. They can add duration easily, and that helps them manage their overall liability mix. But that pension and insurance community, we think, has stepped back a bit. Some foreign demand has reemerged, not from Japan, not from China, but from other parts of the world has emerged. And we've also seen that asset managers have been returning back to the market as yields stop rising. We're also now talking about the possibility that the Fed will go from as active of a net seller through QT. They don't functionally sell into the secondary market, but they're responsible for more supply that the U.S. Treasury in turn has to issue to the private sector. And they're talking about slowing QT. And now we're

wondering, well, if they're slowing, when might they stop? So that is an important determinant in shifting some of the supply demand dynamics in the rates market. So that's a long-winded way of saying that we have seen those supply and demand dynamics shift. Really, demand is returned to some extent, and we remain cautiously optimistic that that demand will persist over the course of 2024, assuming that macroeconomic data continues to play along with the broad narrative of slow moderation over time. Let's talk about quantitative tightening. You know, like I said, in the beginning, there's always been like this one, I guess I would call it like Twitter macro, or it's like one line goes up, another line goes up, they must be connected. And I think the idea that like,

balance sheet policy is some incredible driver of risk asset valuation is kind of debunked. But when we're discussing how far they will go to wind down and at what level that will be, who does that really matter for and why? Like, who are the actors in the market that for whom this is an important debate that they're having? Sure. I generally think of two or three actors for which it really matters in terms of how far the Fed shrinks the balance sheet. First and foremost, commercial banks, because they can be directly impacted by the

amount of reserves or overnight liquidity that the Fed is providing to commercial banks or that is available in the system that commercial banks can try and bid for. The second big actor is Treasury and mortgage market participants for whom, if the Fed is shrinking its balance sheet or growing its balance sheet, the total amount of private sector supply in the Treasury or agency mortgage market can be directly influenced by that. And then the third cohort, and Joe, I think your comments have referred to this on a few times, is sort of the broader risk asset investor. I almost think of them as the quote unquote M2 equity investor, the type of equity investor who just wants to buy or sell equities based upon what's happening with the broader money supply. And this, I will tell you, is a very real cohort of the market, at least as far as the folks who reach out to us on the B of A rate strategy team.

We also view it with a healthy dose of skepticism. We don't believe that there is a particular clear connection between how many reserves, let's say, are in the banking system and then what's going to happen with the equity market. But that doesn't dissuade them. They look back at history and they say, well, when the Fed was growing its balance sheet, risk assets did well. When they shrunk the balance sheet or reserves went down, the opposite happened. And really what we think they are picking up on is the fact that the Fed and other central banks use their balance sheets to almost reinforce the broader stance of monetary policy, right?

So if they're growing the balance sheet, they're typically doing so because they're trying to stimulate activity, lower long-term borrowing costs. And if they shrink the balance sheet, they're generally trying to tighten policy and they're raising interest rates at the same time. So if you think about the balance sheet as reinforcing the broad stance of monetary policy, we think that the M2 equity trading stance makes sense. But we would encourage investors not to blindly follow what happens with the balance sheet or with the reserve quantity and system as an indicator of buying or selling risk. A lot of short daily news podcast focus on just one story. But right now, you probably need more. On Up First from NPR, we bring you three

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There's one sort of under the radar thing at the moment that I think is going to end up being a big deal in 2024, which is sort of the changes around liquidity requirements and regulation for, banks and all of that happening against the broader backdrop of QT. But how do you see that playing out? Because there's a number of things here. So, you know, there are the Basel Endgame proposals. There are LCR suggestions that maybe make those liquidity ratios get a little bit bigger. There's changes to, I have to be careful here because I always end up saying BTFD. The BTFP, not by the Fing dip.

dick, the BTFP and a few other things happening in the background. It is funny though. Can we like you just acknowledge that this was a market mantra for like 15 years and then the Fed came out with an emergency program in March 2023 that sounds so similar. Like let's just acknowledge that is very funny. I had never even heard of that other acronym. Oh really? BTFD, you need to spend more time online.

Dear Fed, you might want to look at Twitter before you do your next acronym. I'm glad we just acknowledge the elephant's the room here. I'm glad we introduced Mark to it. I know. Thank you. I learned something. I appreciate it. All right, but it does feel like changes are coming for the banks, and banks are big buyers of things like Treasury bonds and mortgage-backed securities and things like that. So how do you see all of that playing out? Sure. So we do think that, importantly, with the recent rate hiking cycle from the Fed and what we saw with SVB and some other regional banks, that commercial banks have really changed.

their preferences around liquidity in a meaningful way. And this, we think, will necessitate that the Fed maintain a much larger balance sheet than perhaps they had originally envisioned to really accommodate this demand for overnight liquidity from commercial banks. And we think that commercial banks are demanding much more overnight liquidity for very rational and prudent reasons. The four factors that we typically cite include, number one, we all saw what happened. with SVB, and the best antidote for that, we would argue, is holding lots of overnight liquidity. Number two, commercial banks are still sitting on fairly substantial unrealized securities losses in their treasury and mortgage portfolios. The recent rate rally has helped ameliorate that,

but it hasn't gone away. And again, the best way to fight against those unrealized securities losses is to hold cash. You can tell your shareholders or your regulators, don't worry about the two and a half percent mortgage or so that I bought. I'm never going to have to sell. that for liquidity purposes because I'm holding onto so much overnight cash and I have so many deposits. So don't worry about those securities. We think that's very rational in this type of rate environment. Third reason that banks are holding more liquidity is because they perceive that some of the traditional rules of liquidity management have changed. And this goes into a fairly narrow corner of the funding markets, but it's very important. And it's around the role of the

federal home loan banking system. It's a GSE that arguably had really shifted from its original intention to be a low-cost, stable provider of funding for bank mortgage holdings. And regulators are, well, they've asked, does this evolution of the home loan system make sense? They think not necessarily. And that has really reduced the ability or willingness for, for banks to use the home loan system as a traditional funding source. The market calls the home loans, or at least the home loans have called themselves in the past the lender of second to last resort. And that is now, let's say, not necessarily your second to last resort.

It is lower on the priority list to be used. And then the fourth and final factor is that there is a perception, as you say, Tracy, that there will be additional liquidity rules and regulations coming down the pike. And all of those factors encourage banks to want to hold more liquidity. And the best type of liquidity in the world if you're a bank for all of these reasons is cash at the Fed. It is intraday liquid. And if you need it, if you were to experience a large deposit outflow, you have it at the Fed. You can get it on demand as long as Fed wire is opened.

And that has real value if you are a commercial bank. And as a result of that, commercial banks have been choosing to hold a lot more liquidity. They've been paying up through more elevated sources of borrowing, such as large time deposits, CDs, other forms of term debt borrowing. And they have been doing that in order to hold more cash. And that indicates to us this increased preference to hold liquidity. And if that is indeed right, it's going to mean that the Fed is unable to shrink its balance sheet, perhaps as far as it had originally thought.

Now, the question in our minds is, will the Fed slow down or stop in time to accommodate this? Or will they risk another funding market increase or sharp jump like we saw in September 2019? We don't know the answer to that yet, but folks like me who focus a lot on the plumbing are very, very interested in the guidance that we're going to get from Powell

and others at the Fed as they move forward in this debate and this discussion. Since you mentioned the plumbing, you're talking essentially about the repo madness of 2019. And then we saw a little, I don't want to say a repeat, but a little glimmer of that same issue in, I think it was December of last year, when we saw not LIBOR, but SOFER, the LIBOR replacement rate shoot up kind of unexpectedly in a few days and then come down very quickly. quickly. What was going on there in your mind and how much of a concern should future volatility in the interbank lending market be for those at the Fed and us market commentators?

Sure. So just a quick point of fact, LIBOR was indeed unsecured interbank funding, or at least that's what it was intended to be. Sopher is importantly secured funding that has arguably a wider range of actors involved in that money market mutual funds who are lending cash in that. market, hedge funds who are demanding leverage on the borrowing side in that market. So it is a fundamentally different space. But we do think that signals from money markets are very important indicators of what this demand for liquidity at commercial banks looks like and how much excess cash may be available to keep money markets in check.

Now, how does this actually work? Well, here's our understanding of it. So when we think about the repo market, we think very simply about it. nothing more than the relative balance of cash that is available to be invested in short-term money markets, and collateral that needs to be funded. Really, Treasury collateral is the most frequent type of collateral that we think of, but there's a whole host of other collateral that gets funded, mortgages, credit, EM, etc. But again, we just think about it as in terms of cash and collateral. And what we saw at the end of December, also what we saw at the end of November, is that we saw

repo rates spike for a period of time. In our framework, that simply indicates that there is less cash that's available to fund the collateral that is in need of financing, and henceforth, repo rates go up. Now, what was happening on both sides of that equation? Well, on the cash side, what you see is that dealers typically reduce their intermediation in the repo market due to month-end and especially year-end balance sheet reporting dates. Window dressing is the preferred You said it, not me. It's my preferred term. And we also see that there's big treasury settlements at the end of the month, and there's more collateral that needs to be financed.

And so the repo market is just more susceptible to moving higher because of that cash collateral dynamic that shifts on month ends. Now, this links to what happens with commercial banks and their liquidity preferences, because commercial banks are indeed a big source of cash. and commercial banks we saw in 2018 and 2019, as the Fed was doing QT and that cash collateral balance shifted, commercial banks were big lenders in the cash market at that period of time. They were taking their overnight liquidity, investing in overnight Treasury GCP repo, which is a close substitute, but importantly not a perfect substitute. And we now see again that as repo rates are rising, commercial banks are choosing to lend a little bit more in the repo market, to try and keep GC repo in check.

The question we have, though, is how much cash is there truly to keep these funding markets in check as the cash collateral balance shifts? And will these banks be willing to take that cash that they're sitting on with the Fed that is perfectly intraday liquid and exchange it for T plus one liquidity for a yield enhancement? That is the big question that we ask ourselves. That is the question that the Fed, I think, is asking themselves. And that will ultimately be what we believe is the driver of how far they can actually shrink the balance sheet. Out of curiosity, do you see any interplay with the recent changes to the BTFP, the emergency bank funding program and big banks' willingness to fund repo? It's too soon, I think, to tell. But in theory, you can imagine that there would be a connection because the BTFP for as long as it was going to be available for new loans served as,

a cheap, low-cost source of additional liquidity that banks might want. The liquidity was available on very favorable terms, not just price, but the facility was set up such that it funded treasuries or agency paper at par, not market value. And that's a big difference when you've got overnight rates that are still above 5%. So the fact that BTFP is, well, the terms have now changed and the facility we know will now be going away in early to mid-March, that perhaps means that banks cannot rely on that as another source of very favorable liquidity, and all else equal for prudent liquidity management purposes, might want to hold more cash as opposed to less.

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slash Future Ready. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to lead to, by example, executives making an impact on the IHeart radio app, Apple Podcast, or wherever you get your podcasts. The Fed balance sheet, you know, we didn't talk about, well, I don't know. I was going to say we didn't talk about it much before 2008. But the truth of the matter is I wasn't even in journalism before 2008.

So who am I to say we didn't talk about it much? But I do get the impression that it wasn't as actively on people's minds back then. It was pretty small. It was less than a trillion dollars. Then the financial crisis happened. keeps getting bigger and bigger and now it's somewhere a little less than $8 trillion. Is there a cost to a big balance sheet? Like I get this idea that people think like, oh, we should normalize it or we want to bring it

down, et cetera. But as you know, you described, there are various reasons why large banks, for both regulatory and business reasons, want to have ample liquid reserves. Is there some price or some negative aspect of a large balance sheet? Or is there some, I guess, sound reason why the Fed wants to continue to shrink it? normalize it, whatever that means? Yes, I think there's two key reasons. The first is perhaps a little bit fuzzier. The second is much more practical. The first reason is that the Fed and what they say is that they don't want to have an outsized footprint in financial markets. They don't want

to be distorting financial markets to the extent beyond what is absolutely necessary to achieve their key monetary policy or financial stability objectives. So that's one. But the second reason is much more practical, and that is that there is a cost, a very measurable cost, to having a large balance sheet. If you think about the Fed's assets and liabilities, on the asset side, they pretty much have Treasury securities and mortgage bonds. Those right now are probably yielding all in, somewhere in the neighborhood of two and a half to three and a half percent, all told. But on the liability side of the Fed's balance sheet, there are two big cost items that are there. One is the interest on reserve balances rate that they pay to commercial banks. That rate is currently 5.4%. And then the

other is the rate that they pay on their overnight reverse repo facility. And that is 5.3%. And between the two of these, there is close to $4 trillion that is kept with the Fed and where the Fed is paying a rate that is between 5.3 and 5.4%. So they are very much paying out a higher rate on their liabilities than they are taking in on their assets. And what that has resulted in is that the Fed is actually insolvent. They are running negative nym. And they have seen their capital essentially move into negative territory. And it's over $100 billion now. I think the number is close to $100 or $130 to $140 billion. I can't bring myself to do a drum roll, Joe, but I broke that story when they first went negative. I think it was late 2020.

No, I can't do drum rolls. I can't. So the Fed calls this a deferred asset. And essentially what it represents is the amount that they will withhold in the future to repay the negative equity position that they have got themselves in before they will take any excess income on their securities portfolio and remit that to the U.S. Treasury. Remember when rates were really low, we're near zero, but the curve was somewhat upward sloping. the Fed was buying treasuries and mortgages. They were essentially taking in, I don't even know if it was a 1% coupon at the time, and they were paying out functionally zero on their liabilities. And they were in that position for a very long time. And they used to generate tens of billions of dollars for the U.S. taxpayer, something like $70 billion, $80 billion that they would remit to the U.S. Treasury. Well, now they're not doing that. And they're essentially accounting for this by claiming an IOU that they will repay to themselves to cover these losses before they start those remittances to the U.S. Treasury. And what this means is that the inflows to the U.S. Treasury are lower than they otherwise would have

been. So this is a very real and measurable cost. Now, what's surprising, at least to me, is that this has not been a political issue whatsoever in the U.S. When you think about, well, who is the Fed accountable to? They're accountable to the American public and who is designed to maintain that accountability. It's Congress. Yet when the Fed share goes and testifies in front of Congress, this issue never comes up. And it's very surprising to me that it is not come up. And for what it's worth, this issue in the U.S. is not unique. It's also an issue in Europe, in the UK, but this issue is of much more prominence in those jurisdictions because in the case of the euro area, they literally have to figure out, well, which government is going to pay.

for the negative equity on the ECB's balance sheet. And in the UK, there is quite literally a regime by which they have to raise taxes in order to pay for the negative equity at the Bank of England. In the U.S., we just, you know, it sort of sits there and it's thought that it'll be paid back over time. And it is not an issue of prominence. If it were to be an issue of prominence, if it were to be a larger political issue, then I would think that the Fed would have a greater incentive to try and shrink the balance sheet,

or at least to try and get themselves out of this negative equity position faster, certainly negative NIM position that they are in faster. So again, are there costs? Yes, there are. There are only real costs if, let's say, we care about them. We collectively, as a electorate in the U.S., but that issue, at least in my perception, is very low on the list of Congressional priorities and a list of voting priorities in the U.S.

This is such an interesting topic to me. And again, in addition to writing when the Fed finally went into a negative capital position in late 2022, I had a piece out in March of 2022. And the title of it was, why the Fed losing money might matter for monetary policy. Because as you say, Mark, the conventional wisdom is that like it doesn't really matter. It's all accounting. Maybe it'll be a bit embarrassing if. Powell has to testify before Congress and someone is like, oh, you're losing money. But it does

seem to me like you could get a situation where the central bank does have to adjust something like QT in order to take into account ongoing interest rate expenses. And that could actually affect policy sort of at the margins, it feels like. I agree, at the margins. You know, the Fed is not going to let this dictate their core objective of maximum employment and price stability. But, But if they were getting a lot of heat for it, it would mean that they want to try and shrink the balance sheet arguably by more than they otherwise would have and be less accommodative for the bank demand for liquidity that we were discussing earlier, or that they might try and move the prices that they pay on the core liabilities that they have. Again, cash that's sold by commercial banks or overnight investments that money funds are making with the Fed, they might try and move those lower all-a-s sequel. And it's perhaps not an issue if it's not top of mind for, let's say, those who hold a Fed accountable. But it certainly could be if those dynamics do change.

Under current political dynamics, which is Congress probably doesn't care that much because, you know, it's probably not going to be a big, you know, voting issue in November would be my guess. But under current dynamics of the degree to which people care and everything, what is your forecast for where the balance she goes here? Yeah. Everything we've talked about. So we have an out-of-consensus view in that we think that the Fed is going to be slowing QT a little bit earlier than expected. And likely wrapping up by, let's say, mid to late summer, the QT program, that would see the Fed's balance sheet likely in the neighborhood of $7.5 trillion. It's about $7.75 trillion right now.

And the reason for that is that we think that they will be a bit more accommodative and willing to provide. the necessary liquidity that we perceive that commercial banks are demanding. Now, the Fed as they think about how far they want to push QT, has to be mindful of the lessons that they learned in 2019. Banks were demanding more liquidity than they thought. They shrunk the balance sheet by too much, and they caused that unnecessary repo market volatility. And what they are likely debating today and perhaps tomorrow is how far do they want to push it this time? When might they slow down QT and what are the considerations that they will be looking for? And we do. believe that this very technical facility that they have set up called the overnight reverse

repo facility, which is again a facility whereby primarily money market mutual funds can invest cash overnight with the Fed on a fully collateralized basis, mostly by treasuries, they're asking themselves, well, when might they slow QT in relation to how utilization of that facility is evolving? And we do think that this is really important because we believe that as long as there is excess cash that money market mutual funds are choosing to invest with the Fed on an overnight basis, as long as those balances are positive, we think that there is clearly excess liquidity in the system. If there's excess liquidity, then the Fed should feel comfortable proceeding full steam ahead with QT. But once those balances are exhausted or very low, then the Fed might want to

think about slowing things down. This was an argument that we heard earlier this month from Dallas Fed President Lori Logan. She suggested that she would propose slow. slowing QT once overnight RP balances were low, now very ambiguous, low level. We think that that means balances that are 200 to 250 billion, but we don't really know for sure. So she wants to slow down once those balances get low because she wants to proceed more cautiously thereafter and ensure that the Fed doesn't inadvertently withdraw too much liquidity from the system. Again, she wants to accommodate or so it seems that demand that commercial banks have to hold liquidity and we'll be using the overnight RRP

as perhaps the best single indicator for the amount of excess that's in the system. We think that that line of reasoning is very, very sensible. Wait, what about bank reserves? Because before the overnight RRP existed, it was always about the level of what is ample and what is not in bank reserves.

That's right. And that's what they're really trying to solve for. They want to move from a clearly abundant, and they use these words, abundant and ample. But they don't define them in any way, which kind of makes it feel a little buzzy, and a little unclear. But they say that they want to move away from an abundant regime of reserves

to an ample regime of reserves. Again, definitions are unclear what the distinction is. And I think we can say that when money market rates were really low, when overnight RRP facility utilization was very high, they were clearly abundant. There was a bunch of excess liquidity in the system, and the overnight RRP helps proxy for that. However, once RRP is exhausted and it's been dropping very, very rapidly, once it's exhausted, then it's not so clear that you are in such an obviously abundant zone, and you are probably moving along the lines of from abundant to ample. I know, it's so good. Yeah, these buzzwords. And...

What comes after ample, adequate? Oh, that's good. Yeah. Abundant, ample, adequate. Yeah. I don't know. Non-ample? Yeah.

I don't know. I like adequate. An adequate reserves regime. That's good, tracing. But the point here is that you don't know if you're the Fed where you are on that path and they don't want to push it too far. So what's going to help them determine this? Money market rates. So far, where that trades within their target range, how much cash commercial banks were sitting on a big quantity of cash or going to be willing to invest in funding markets in order to keep money markets stable.

and as you see money markets rise and as you see banks move some of the money and perhaps slow down the movement of some of the excess cash that they are holding, that should be a very clear indicator to the Fed that they have gone far enough and that they should slow things down. Now one final point that I'd like to make on this is just that the Fed is also likely very well aware. The demand for reserves is not static. It's dynamic. It shifts with macroeconomic conditions and importantly it shifts with interest rates. We talked earlier about all of the reasons that we believe commercial banks are demanding a higher quantity of liquidity today. SVB went down, unrealized securities losses, changes in liquidity regs, past and perhaps upcoming. But when you think about what happened

with SVB and when you think about what happened with the unrealized securities losses, it's really a function of interest rates. And if the Fed were to hypothetically, say, cut interest rates, 300 basis points, very swiftly. Probably not going to, but if they were, we very strongly suspect that bank demand for reserves and bank demand for liquidity would go down because they would be more confident in their deposit stability. Those uninsured deposits wouldn't run as fast because they have, you know, depositors would have less attractive alternatives. And your unrealized losses on your securities portfolio may completely go away if rates are substantially lower. So, the Fed likely is aware that demand for reserves is varying with macroeconomic conditions, is

varying with interest rates. And being more careful when interest rates are high and you've been doing QT quickly seems prudent, though you can question how long you might be able to run QT, especially if the interest rate regime is substantially lower than where it is today. Yeah. It is true that I think reserves are at something like $3.4 trillion now, and they were less than $3 trillion right before the mini banking crisis. So they do move around quite a bit. Mark, that was amazing. Thank you so much for coming on and sort of threading the needle between what's going on at the banks and in bond markets and with the Fed. Really appreciate it. Thanks so much for having me. That was great, Mark. Really appreciate it. Thank you.

Joe, that was such an enjoyable conversation. Mark is so clear on a lot of these topics, which other people sometimes either seem to struggle with or obfuscate for various. reasons, but that was great. That was great. I totally agree with that. Like, these are topics, like, when you get into the stuff where it's easy to sort of get lost in the sea of like, I'm not really sure what's going on. Mark was so clear. And the way he like broke it down. So that last point actually, I thought was super interesting about the relationship between rates policy and total demand for reserves, which is not something, I guess I had like quite heard like put in pieces like that, but like this idea that, you know, if unrealized losses are

going to fall. If there's less competition for rates elsewhere, then banks feel less of an impulse to hold overnight liquidity, like very clear and not something that I had quite like put together quite like that. Yeah, also makes a lot more sense why the Fed might be looking at something like the overnight RRP, the repo for signs of liquidity versus reserves in the system. The other thing, it just brought back to me the sort of blast from the past when we were talking about the Fed reporting a loss. I remember, this is how old I am. I remember writing in 2011 when the Fed changed its accounting rules so that it couldn't

like actually go bankrupt. It changed it so that like the most it could do is report a sort of negative position on assets. I feel old. Well, it's a good reminder actually. The Fed can write its own accounting rules. Like these are, you know, it's like people look at this stuff. The Fed's insolvent or whatever.

It's like who determines that. To your point, and I didn't even realize that. I had forgotten or maybe I never knew that in 2011 that the Fed had changed its accounting rules to avoid any problems. But it is a good reminder that if you can write your own accounting rules, that makes life easier. Well, and I think the issue was that it wanted to avoid a situation where if it had a loss, it would have to go to the Treasury for capital top up. Which makes sense. And then that could be a sort of vulnerability in terms of independence. So they just rewrote the rules. that they didn't have to do that, basically. Yeah. Wouldn't it be nice? If we all could write our own accounting rules.

Yes. Anyway, we'll have to get Mark on again. Yeah, he was great. That was really good. I'm glad we finally had them on. All right, and a big week for markets, lots going on. It'll be interesting to see how everything shakes out. But in the meantime, shall we leave it there?

Let's leave it there. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Wisenthal. You can follow me at the Star Wars. follow our producers, Carmen Rodriguez at Carmen Armin,

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