Crypto markets up ~ Traditional markets positive... Now, a short story on the liquidity of money. Will quantitative tightening (QT) become the new normal?

We’ve seen a (so-far) once-in-a-lifetime event occur with the FRED M2 registering its first YoY decline to $21.2T (Dec-22) vs. $21.5T (Dec-21), having peaked at $21.7T (Mar-22). While the $0.5T contraction (from Mar-22 to Dec-22) accounts for just 9% of money printed ($5.8T) since Jan-20. In general, QT is seen as a tightening of financial conditions, leading to lower asset prices via higher yields.

The $0.5T contraction stems from the Fed’s commitment to QT, with Fed Governor Waller suggesting last week that the (US, i.e. global) banking system had sufficient liquidity, important as the Fed operates an ample (no longer scarce) reserves regime, and pointed to the $2 trillion of excess cash sheepishly sitting in the Fed’s o/n rrp facility.

For liquidity, Waller suggested QT would be maintained during a period of rate cuts (i.e. a declining Fed Funds Rate). Question for Governor Waller, who views every trillion of QT equating to a 25bps tightening, is how integral the Fed’s standing repo facility (SRF), a backstop measure and somewhat replacement of the retired discount window, will be to maintaining liquidity.

The SRF forms an important appendix to stem money market volatility, as we saw during the previous QT cycle (2019), GC repo borrowers were hit with (uncharacteristically) volatile overnight rates (EFFR, SOFR), specifically on 16 & 17 September 2019. The SRF (starting in July 2021) allows the temporary expansion of the Fed’s balance sheet to accommodate intraday and overnight liquidity crunches.

There is a high chance the SRF will be tested this year, as the market direction (up / +ve) maintains divergence from the Fed’s new normal (down / -ve), pushing liquidity to the fringes. As Perry Mehrling famously said, “In finance, a lack of liquidity “kills you, quick,” only question is whether the SRF will be liquidity’s antidote.

As we noted in our 13 Jan 2023 weekly recap, the Fed adjusted its monetary policy transmission from the FFR to IOR and, as such, banks (via loan creation = asset returns) are back to presenting systemic risks, where any liquidity crunch (Libor-OIS) will test the new Fed regime, during another period of QT. The only thing we can say is, “Take a view on how you think history will rhyme.”

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