The Fed has already started down the path to resuming quantitative easing.
The question is whether they do so before, or after, upending the highly-leverage hedge fund basis trade that has been supporting the Treasury market.
Back in 2018, quantitative tightening - the undoing of Fed asset purchases - was a simple affair. As bonds matured on the asset side of the Fed balance sheet, banks would draw down reserves on the liability side to buy bonds. The question then was how low reserves could go before they would become ‘scarce’ and the Fed would have to stop QT. In the end, the Fed went too far, causing strains in overnight markets. They reversed the ship in 2019 and resumed QE to maintain a ‘floor’ system for setting rates.
This time around, QT has been complicated by the presence of large amounts of money market fund cash sitting in the Fed’s Overnight Reverse Repurchase Facility, or ON RRP.
In 2023, it was the ON RRP that declined alongside Fed assets, and bank reserves actually rose.
The assumption has been that ON RRP drainage was protecting bank reserves and that, only once these reserves started to fall would we have to worry about a rerun of 2018. The Fed also now has a backstop for the banks - the Standing Repo Facility - that can be drawn down in the event of unexpected liquidity squeezes.
But the ON RRP may have been playing an altogether riskier role in bond markets - financing the proliferation of the so-called hedge fund ‘basis trade’, whereby hedge funds borrow to buy Treasuries and sell Treasury futures to make a tiny return, leveraged up multiple times.
This trade has caught the attention of regulators on both sides of the Atlantic.
The problem is that the basis trade is financed in the private repo markets, and it is money market funds - drawing down their ON RRP cash - that are financing this trade.
The box diagram below, from the New York Fed, shows how ON RRP money can end up financing hedge funds (“Non Bank Financial Institutions”) repos:
Levered NBFIs Purchase New Treasury Securities © New York Fed
This has created the possibility of a worrying chain reaction - from the Fed’s balance sheet, via the money market funds and the private repo market, through the basis trade and on to the demand for Treasuries, at a time when the US government is coming to market with massive amounts of issuance.
Instead of scarce bank reserves creating liquidity problems and forcing the Fed to stop QT, it may well be the exhaustion of the ON RRP and the upending of the hedge fund basis trade that causes problems in 2024. The worrying difference now is that there is no Fed backstop for hedge funds and the high degree of leverage used in the trade could lead to liquidity problems proliferating even more quickly through the financial system.
It seems unlikely that the Fed is unaware of this issue.
Indeed, it may be no coincidence that Fed messaging on QT is already shifting, with Dallas Fed President Lorie Logan already suggesting that QT should taper once the ON RRP runs dry.
This may be too late to avert a severe bout of bond market volatility, though.
Either way, the Fed is on course to end QT and restart QE in the coming months, against a backdrop of loose fiscal policy and a still-resilient economy, opening the door to a reappearance of inflationary pressures that the Fed may have little appetite (or ability) to restrain.
