Long-Duration Trades, Federal Reserve Policy, and Shifting Landscapes in 2024
Diving into the intricacies of real-money investments, my primary concentration revolves around the dynamics of long-duration trades. It remains imperative to maintain a vigilant stance to discern potential strains within the money market.
Just over a month ago, I posited the possibility of the Federal Reserve’s quantitative tightening (QT) program extending into the year 2024. This prediction hinged on the belief that the existing level of reserves within the system is more than sufficient to sustain an indefinite balance-sheet runoff. As of now, reserves stand at an impressive 83 trillion (originally 53.5 trillion), exhibiting a marginal upward trend since the conclusion of March.
However, a prevailing sentiment on Wall Street suggests the Federal Reserve might find itself compelled to cut or scale back QT in the early months of 2024. This speculation is grounded in concerns about tightening liquidity in specific segments of the Treasury market, potentially necessitating the Fed’s intervention. Recent, albeit brief, funding strains served as a stark reminder that even the world’s most liquid market can encounter challenges capable of abruptly halting QT.
In response to the repo market seize-up of September 2019, the Federal Reserve took decisive action, suspending QT. This involved the implementation of special repurchase operations and a reduction in administered rates. The central bank committed to purchasing $60 billion in Treasury bills through the second quarter of 2020, effectively putting QT on hold. Bank reserves, which had dipped to just over 9% of GDP during the repo market stresses, have now rebounded to around 11%. Yet, the timing of the transition from a state of “abundant reserves” to an “ample” regime remains uncertain. A recent survey indicated that over one-third of financial officers prefer holding additional reserves above their lowest comfortable level, anticipating potential scarcity into 2024.
The rapid drainage from the Federal Reserve’s Reverse Repo facility (RRP) has been a notable occurrence, with usage plummeting from approximately $2.2 trillion in May to a recent figure of $683 billion. Despite this marked decline, there hasn’t been a corresponding reduction in bank reserves. Anticipating a substantial decrease in the RRP facility to half a trillion dollars early next year, potentially depleting entirely by the end of 2022, we might witness a meaningful decline in bank reserves. Chair Powell himself acknowledged the potential conclusion of the RRP drain, leading to a subsequent decrease in reserves.
While my prevailing view is that QT will continue into 2024, the ongoing developments in the RRP and their cascading impact on reserve balances necessitate a heightened level of scrutiny. As we approach the year-end, data reflects a persistent preference among real-money investors for long-duration trades, particularly evident in the 10y+ and 7-10y buckets. Cautionary notes are sounded for the back end of the curve, as concerns about supply into 2024 might eventually counteract the prevailing trend. Currently exercising caution, I foresee the supply issue gaining increasing prominence in the market’s focus as we transition into 2024.
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