US Federal Reserve Chair Jerome Powell has been talking himself hoarse lately. Ever since he failed to push back against the market’s overly ebullient expectations for rate cuts following the December 2023 policy meeting, he has told anyone who’d listen the Fed isn’t ready to declare victory over inflation. His press conference in January this year and a ‘60 Minutes’ TV interview didn’t do the trick; neither has sending forth nearly every Federal Open Market Committee (FOMC) member to shout this message from street corners.
In an appropriate twist for the data-dependent Fed, it was a series of economic reports that stemmed the tide. Robust gross domestic product (GDP) and employment figures, sticky wage, consumer and producer inflation, and respectable manufacturing and housing numbers did what the policymakers could not. In late December, futures contracts predicted upward of seven quarter-point cuts in 2024. Following the bump in month-over-month core personal consumption expenditures (PCE) in January, they have priced in essentially three – in line with Fed projections. That’s why we – and really everyone – anticipates no rate action at the mid-March or early May policy-setting meetings and expect the first ease to come in June or July.
Market participants will surely raise their fists to the Fed again, and it is understandable. Powell and company were so behind the ball when they first tightened rates long after inflation had exploded. But the shift in sentiment, along with the pause itself, has benefited cash managers and investors. Across the liquidity industry, elevated yields and extended average maturities have created better relative value in our humble opinion.
Market participants will surely raise their fists to the Fed again, and it is understandable.
This means the street can worry about something else, and the Fed’s balance sheet and Reverse Repo Facility fit that bill. The latter is actually a good sign. The sharp reduction in its use does not mean the supply of collateral or repo is too low, but that it is coming from traditional dealers instead of the Fed. Once above US$2tn, the Fed is accepting around US$570bn recently, and we think it will hover even lower than that for the near future.
The pace and ramifications of quantitative easing also should not spark concern. It’s been so long since it’s been a focus, my guess is more than a few have forgotten the exact numbers ($95bn in government securities, split between US$60bn in US Treasuries and US$35bn in agency mortgage back securities) rolling off each month. The balance sheet had ballooned to US$8.9tn but sits at around US$7.6tn now.
The point of contention is that it will shrink too far, lowering reserves and reducing market liquidity. In the back of the policymakers’ collective mind is to avoid a spike in overnight rates like what occurred in September 2019. This should not happen. Not only is the balance sheet much larger now, but also banks hold more reserves to ensure liquidity. Short of a revolt in the bond market, the taper should continue smoothly with a target of between US$6tn and US$7tn and end in 2025. But this depends on how well the Fed communicates the process, starting in the upcoming FOMC meeting – and if the markets listen.
Money market rules
The next compliance implementation stage of the US Securities and Exchange Commission’s (SEC) 2023 money market regulations arrives on 2 April . With this date comes an increase in requirements for liquid assets among other less-monumental changes. Money funds will have to maintain at least 25% in daily liquid assets (previously 10%) and at least 50% in weekly liquid assets (previously 30%). Tax-exempt money funds are not subject to the daily requirement. We, and likely any firm in the liquidity business, have been stress-testing funds to prepare and are quite satisfied with the results that sufficient liquidity will be maintained in even the worst-case scenarios. Of note is that the recent flattening of the short end of the money market yield curves likely means this shift won’t be very punitive on prime money fund yields. That’s because the difference between yields on weekly securities and those on the longer end of the liquidity yield curve has diminished.
Liquidity at large
It’s Monetary March Madness as most of the world’s central banks will hold policy-setting meetings in the coming weeks. That includes the Bank of England, Bank of Japan, European Central Bank, Bank of Canada and, of course, the Fed. None have changed rates this year and are unlikely to this month. With the exception of Japan, officials are mimicking the Fed in delighting that inflation has fallen while acknowledging it must decline further before cutting rates. For some, the bigger news is the announcement the UK will issue banknotes featuring the image of King Charles III in June.
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