There is still $1 trillion in Fed liquidity that will gradually flow into the private sector after QE stops. A large chunk of liquidity created by QE over the past two years never entered the banking system, but instead sat first in the Treasury’s Fed account and later in the RRP Facility. In the coming months Treasury will restart bill issuance and draw those funds out of the RRP into the TGA, and then spend those funds into the banking sector. Over time that will leave the banking sector with about $1t more in reserves, and the non-banks with a $1t more in deposits. If the past is any guide, that suggests more portfolio rebalancing where banks will purchase more Treasuries and non-banks more risk assets. In this post we trace the recent flows of Fed liquidity, show why more liquidity will soon flow into the banking system, and suggest that it will be a tailwind for all asset classes.
Fed pays for QE purchases by printing reserves, which are essentially digital cash issued by the Fed that only entities with an account at the Fed can hold. Those reserves usually end up in one of three account types at the Fed: banks, Treasury’s Fed account (“TGA”) or the RRP. The tremendous amount of reserves created by the Fed last year largely ended up in the Fed accounts of commercial banks, but a sizable chunk also found its way into the two other account types. Note that increases in reserve assets held by banks are also mirrored by an increase in deposit liabilities due to our two tiered monetary system. QE increases reserves (money for banks) and deposits (money for non-banks).
Around $1.5t of the QE liquidity created last year was held by Treasury and never made it into the banking system. At the time, the Treasury was anticipating potential stimulus legislation so it kept a large precautionary TGA balance. As that became unnecessary and with a looming debt ceiling, Treasury began to spend down its TGA balance by repaying Treasury bills (short-term debt). Those repayment flows largely went to money market funds (“MMFs”), who are the largest investors in Treasury bills. The MMFs had no where to reinvest those funds so they just deposited them into the RRP facility, which currently has a balance of about $1.5t.
The $1.5t of QE liquidity that has been sitting in either the TGA or the RRP for over almost two years will eventually enter the banking system. The mechanism for that entry is through increased bill issuance and a lower TGA target.
Bill Issuance Drains the RRP
Bill issuance trends higher because the Federal deficit only goes higher, but there are also two developments next year that will increase bill issuance. First, the debt ceiling will (eventually) be resolved and free up space for more issuance. Second, Treasury will likely shift its funding mix next year towards a higher percentage of bills even as it cuts coupon issuance. An anticipated rapid taper of the Fed’s sizable $80b monthly purchases amidst perceived Treasury market fragility may compel the shift. Although Treasury was advised to issue 15 to 20% of debt in bills, Treasury also recently commissioned a study that suggested flexibility in that target given the high level of cash in the RRP. In this context the prudent and lower cost path is likely to issue more bills at the current rock bottom rates.
The bulk of the issued bills will likely be purchased by MMFs, who are the dominant investors in bills. MMFs have around $1.5t deposited in the RRP just waiting to be invested in any safe asset yielding more than the RRP offering rate of 5bps. Treasury will use some of the issuance proceeds to build up the TGA account from its debt ceiling lows. But with no emergency stimulus plans in sight the TGA will stay far below its 2020 level of ~$1.5t and instead hover around a few hundred billion. Treasury appears to be modeling a $650b target next year, leaving around $1t of reserves to flow into the banking system.
Into the Banking System
A short series of transactions moves money out of the RRP and ultimately into the banking system. From the Fed’s perspective, money moves out of the RRP and into the TGA when a MMF buys a Treasury bill (lends Treasury money), and then the moves from the TGA into a bank’s Fed account when the Treasury spends it. All these flows are just changes in the Fed’s accounting software, where numbers are moved from one account to another.
From the private sector’s perspective, the Treasury’s spending increases the level of reserves held by banks and deposits held by non-banks. In essence, QE liquidity that was already created is making it way into the private sector after a delay. The timing of the flows depends largely on the path of bill issuance, but persistent deficits mean eventually the entire $1.5t in the RRP will flow into the banking sector (minus a few hundred billion to top up the TGA).
The financial and economic impact of QE is intensely discussed, but few would dispute that it boosts financial assets. One channel through which this occurs is via the mechanical rebalancing that happens when a chunk of low yielding assets is pushed onto the private sector. Banks rebalance out of low yielding reserves into Treasuries, and non-banks rebalance out of 0% bank deposits into riskier or higher duration assets. The end result is a rally in all assets that market observers have come to appreciate.
To the extent this mechanism describes the impact of QE, then there is effectively $1t more of QE coming down the pipeline.