Key Highlights

• The Fed is concerned about debt ceiling dynamics and the balance sheet
• January minutes go as far as suggesting pausing QT; we don’t think this is likely until after the debt ceiling is resolved
• Yield pressure should abate in the short term, but yields around 5% still likely by H2 2025

Minutes raise QT uncertainty while debt ceiling remains unresolved

EXHIBIT #1: COULD QT LEAD TO FUNDING MARKET STRESSES?

^{Source: Federal Reserve Bank of New York, Federal Reserve Board of Governors, Bureau of Economic Analysis, Bloomberg}

Our take

January’s FOMC minutes, released last week, had very little new information on the policy outlook, confirming the extended pause in the rate cycle, something which had been previously communicated by Chair Powell in his recent testimony to Congress as well as a number of Fedspeakers subsequently. That doesn’t render the entire document perfunctory, however. In addition to a discussion of balance sheet runoff and debt ceiling dynamics, there was also concern about the impact on reserve levels, and by implication, funding markets.

The debt ceiling episode leads to rising reserves (as the Treasury spends money out of its General Account) and curtails T-bill issuance, leaving money market funds to deploy their cash in instruments other than Treasury securities. During this period, funding markets will function as if they are awash in liquidity, only to potentially see a rapid decline in liquidity once the debt ceiling is resolved, the TGA is replenished and bill issuance resumes. See here and here for our recent discussions on these topics.

It turns out that the System Open Market Account (SOMA) manager at the New York Fed had similar concerns. From the minutes: 

“The manager also noted that a range of indicators continued to suggest that reserves had remained abundant over the intermeeting period. However, the manager cautioned that the debt limit situation may cloud the signals …. In addition, reserves might decline quickly upon resolution of the debt limit and, at the current pace of balance sheet runoff, might potentially reach levels below those viewed by the Committee as appropriate.”

In other words, it may look like reserves are abundant as debt ceiling-related factors come into play, but this could prove to have been a mirage once reserves start to drain, forcing the Fed to slow or more likely stop QT at that point. Since the beginning of the year, when asked by clients about our view on when QT would be terminated, our reply has been that it would happen at the first FOMC meeting after the debt ceiling is resolved. We still think this will be the case.

However, further into the minutes, during the participants’ discussion of current conditions and the economic outlook, QT concerns seemed to be even more acute (bold is our emphasis): “Regarding the potential for significant swings in reserves over the coming months related to debt ceiling dynamics, various participants noted that it may be appropriate to consider pausing or slowing balance sheet runoff until the resolution of this event.”

We don’t know how many participants the minutes mean by “various,” but this suggestion was newsworthy enough to merit highlighting in the document. The fact that potentially “pausing” or “slowing” balance sheet runoff was brought up and reported on means we have to take this suggestion seriously.

The Fed had to confront significant funding market stress in September 2019, about 18 months after the post-GFC balance sheet runoff began. Ultimately it had to reverse QT and expand its balance sheet to supply sufficient liquidity to confront the seize-up in money market rates at the time. Exhibit #1 shows how reserves fell to extremely low levels (especially relative to the size of the economy – less than 7% of GDP) after a year and a half of QT. However, looking at the current level of reserve balances, still well north of $3trn – or nearly 11% of nominal GDP – we still don’t believe reserves that are currently considered “abundant” will become merely “ample” in the coming months.

If the Fed is really concerned about funding market stresses due to limited liquidity, it could pause QT in March or, more likely if the debt ceiling isn’t resolved by then, May. But we think it would be difficult and not entirely appropriate to restart QT upon resolution of the debt limit episode. In the absence of any debt ceiling-related disruptions, we think QT would probably have had to end by late summer or early autumn anyway, so why pause, restart and then terminate it a few months later?

Through last Wednesday, the TGA has fallen from a recent high of $842bn a week earlier to $738bn, and we expect the drawdown to continue. Through February 12, Treasury had less than $100bn left in extraordinary measures, which it initiated on January 21. This means the TGA must continue to be spent down from here.

The X-date is still highly uncertain, depending on how much tax revenue is collected in April, but most observers reckon that it could stretch out through the end of July. This seems to be creeping into market calculations as well. Exhibit #2 shows the current T-bill curve. Note the slightly upward sloping section highlighted in orange. This implies that investors are – on the margin – avoiding bills dated in late July and August. This cheapness isn’t significant yet, and could have more to do with the switchover from 6m bills (which mature at that time) and longer dated, less liquid securities.

EXHIBIT #2: BILLS STARTING TO SHOW DEBT CEILING CONCERN

^{Source: Bloomberg}

Forward look

This means our call for 10y yields to eventually get to 5% is highly at risk. We acknowledge that in the short-term, pressure on yields to fall is more likely. The discussion around QT is bond-positive, as is an oblique remark in the minutes suggesting that GSIBs’ Supplementary Leverage Ratio could be up for discussion, potentially relieving capital burdens on large banks and opening up additional balance sheet room to hold more Treasurys.

We still believe that over the medium term US yields will move higher – toward 5%, primarily due to excess supply that will come with the new administration’s tax and spending plans. For now, though, yields at or under 4.5% don’t seem unreasonable.