There is an abundance of liquidity floating around the financial system, thanks to the Federal Reserve’s efforts to support the U.S. economy since the outbreak of the pandemic in March of last year.
And even if the central bank completes cutting its $ 120 billion in monthly bond purchases next year, “liquidity should continue to grow and remain plentiful,” strategists at JPMorgan Chase & Co. said on Friday in a note.
This is important because investors and markets were assuming that a reduction – or a withdrawal of the Fed’s quantitative easing – would be a first step towards tighter financial conditions, before the central bank’s decision to raise interest rates. The question in many minds has been whether, when, and to what extent the Fed could start cutting back on buying – with still fresh memories of the tantrum tapping episode of 2013, which led to surging yields to long term.
JPMorgan’s analysis casts cold water on the hypothesis that the reduction alone will be enough to tighten conditions as much as many people think.
“Even if the Fed completes its cut next year, the record amount of cash in the system will remain,” Teresa Ho, one of the note’s authors, said in a follow-up email to MarketWatch.
Only a contraction of the Fed’s balance sheet would lead to lower liquidity levels and “this is unlikely to happen anytime soon,” she said. Based on this consideration alone, “we do not expect any significant tightening in financial conditions once the Fed completes its withdrawal,” although tightening could still occur through a rate hike.
As part of the Fed’s accommodative monetary policy, the central bank has regularly injected liquidity into the system through monthly bond purchases, inflating its balance sheet by $ 4 trillion since March 2020 and pushing the amount of financial system reserves at record levels.
Uncertainty over the timing and pace of the Fed’s cut “means reserves will likely continue to rise, at least for the next 6 to 12 months, potentially totaling an additional $ 1,000 billion,” according to JPMorgan. Ho estimates that the current minimum amount of uninvested cash – or “money that has literally left the banking system and has nowhere to go” – is just over $ 950 billion.
The main beneficiaries of the Fed’s QE, in dollar terms, have been bank deposits and money market funds, according to Ho and strategists Alex Roever and Kabir Caprihan. At some point, however, investors could start to move away from these options and “look to bonds or other high-yielding asset classes,” they said.
This is important because it suggests that the bond rally earlier this week, which sent the 10-year TreasuryBX: TMUBMUSD10Y to its lowest level in almost six months, may have more leeway. But Ho says that’s not necessarily the case as it’s unclear where excess cash that hasn’t already been invested “ultimately gets reallocated.” “Much of the money is institutional, owned by businesses, governments, states and local governments, and other owners, who may decide to spend it as needed. Some may decide to keep excess cash in cash. ”
Read: From banks to businesses: more deposits, please
Recent readings of US inflation well above 2%, along with a strong July jobs report released on Friday, helped open the door to the notion of a Fed that might be ready to take a more hawkish turn. This week, Dallas Fed Chairman Robert Kaplan told Bloomberg News that the central bank should start cutting back on asset purchases as soon as possible. And Fed Vice Chairman Richard Clarida has said he could get support for an announcement to cut bond purchases this year, if the economy turns out as he hoped, and enough progress is made. could be achieved on the central bank’s targets for policymakers to start raising interest rates in early 2023.
JPMorgan is not alone in concluding that tapering will not be enough to tighten financial conditions: Senior trader David Petrosinelli of InspereX, an underwriter and distributor of securities, agrees. He adds that “yields are not going to rise significantly with this wall of money unless Fed officials start raising rates or the market helps them by pushing yields higher because there is a lot of money for too few assets “.
Many institutional investors, such as banks and insurers, “are still sitting on a ton of cash” even after this week’s bond rally, he said, citing anecdotal reports. And the recent surge in inflation has “exacerbated the productive deployment of cash balances in banks, insurance companies and other institutional investors,” he said by telephone on Friday.