The money supply is set to contract just as investors are clamoring for cash to hide from declines in both equities and bonds. A combination of increasing MMF allocation to the RRP and QT may drain ~$1t of bank deposits by the end of the year. The Treasury’s decision to further cut bill issuance will keep money market rates very low and likely push the RRP to over $2.5t by the end of the year. Furthermore, recent history suggests QT will largely be funded by deposits held in banking system rather than the RRP. The combination of these two mechanisms suggests a net contraction in bank deposits despite elevated bank credit creation. Investors looking to hide in cash will have to compete for a shrinking pool of cash by further lowering the asking prices of their assets. In this post we describe the mechanics behind the impending rapid withdraw of cash and suggest the market rout will continue.
QT To Drain Banking System
The current configuration of the financial system suggests that QT will be funded out of the banking system rather than the RRP. QT can proceed in a number of ways, where drains from the RRP are most neutral. That occurs when money market funds (“MMFs”) withdraw money they invested in the RRP and lend it to leveraged investors to purchase Treasuries. In that case, QT would leave the level of money like assets (bank deposits/MMF shares/reserves) in the financial system unchanged. As the financial system is opaque and constantly changing, it is not obvious beforehand how it will react to QT. The most straight forward way to predict its reaction is to look at recent history.
Treasury’s 2022Q1 build up of its Treasury General Account (“TGA”) is mechanically similar to QT and was funded almost entirely from the banking sector. Once the debt ceiling was resolved last December, the Treasury increased its balances in the TGA by $600b through debt issuance. That action has a similar effect to QT, except that QT would extinguish the funds rather than leaving them in the TGA. This natural experiment suggests that the financial system as currently configured will accommodate QT by draining bank deposits and reserves (see here for details). Note that the RRP not only did not decline, but actually rose throughout 2022Q1. Leveraged Treasury investors are not increasing their activity, so a smooth QT does not appear likely.
RRP to $2.5t and Beyond
The tightening effects of QT will likely be compounded by a significant rise in RRP participation in the coming months. The Treasury has indicated it intends to further cut bill issuance by ~$600b amidst unexpectedly high tax receipts. The decline in the supply of bills and a general ‘risk-off’ sentiment has pushed money market rates to trade significantly below the expected path of the RRP offering rate. Other than a small set of “Treasury Only” funds who can only buy Treasury securities, MMFs will continue to be attracted by RRP’s relatively high return and overnight tenor. A sizable fraction of the ~$2t in Treasury and Agency securities MMF currently hold are likely to be reinvested into the RRP as they mature.
MMFs reinvesting maturing investments into the RRP drains liquidity held in the banking system. A MMF receives bank deposits from maturing investments, but those deposit are destroyed when the MMF sends those deposits over to the RRP. At the end of the day, the transaction has a similar effect to QT in that it lowers the level of cash available to banks (reserves) and non-banks (bank deposits). Note that this is a different case from increases in the RRP from MMF investor inflows, which is more neutral as non-bank investors simply swap bank deposits for MMF shares.
Closing the Exits
Cash is the only asset that has been spared from the recent market route and it is set to become scarcer. Bonds are not acting as a hedge and appear to be becoming less ‘money’ like due persistent declines in price and elevated rate vol. Investors in both bonds and stocks are reaching for cash by selling their assets, driving further asset price declines. For non-bank investors, “cash” means bank deposits. A $500b increase in the RRP and $400b in expected QT would drain the pool of bank deposits by ~$1t by year end. As the pool of bank deposits declines or stagnates, investors may need to continue to lower their selling prices to compete for the cash they want.
Note that bank credit creation continues to expand, but it does not look like it can offset the rapid tightening. Recall, banks create bank deposits when they make a loan or purchase an asset. The pace of credit creation this year has so far been historically high, but the level of bank deposits has actually declined from the rising RRP and recent tax payments. QT and further increases in the RRP will continue to push against net bank deposit creation throughout the year. Unless credit creation in 2022 rivals the historic growth seen last year, bank deposits look set for the first annual decline since the early 90s.