From Joseph Wang, FedGuy (personal views of a former fed trader), May 31:
The money supply is set to contract just as investors are clamoring for cash to hide from declines in both equities and bonds. A combination of increasing MMF allocation to the RRP and QT may drain ~$1t of bank deposits by the end of the year. The Treasury’s decision to further cut bill issuance will keep money market rates very low and likely push the RRP to over $2.5t by the end of the year. Furthermore, recent history suggests QT will largely be funded by deposits held in banking system rather than the RRP. The combination of these two mechanisms suggests a net contraction in bank deposits despite elevated bank credit creation. Investors looking to hide in cash will have to compete for a shrinking pool of cash by further lowering the asking prices of their assets. In this post we describe the mechanics behind the impending rapid withdraw of cash and suggest the market rout will continue.
QT To Drain Banking System
The current configuration of the financial system suggests that QT will be funded out of the banking system rather than the RRP. QT can proceed in a number of ways, where drains from the RRP are most neutral. That occurs when money market funds (“MMFs”) withdraw money they invested in the RRP and lend it to leveraged investors to purchase Treasuries. In that case, QT would leave the level of money like assets (bank deposits/MMF shares/reserves) in the financial system unchanged. As the financial system is opaque and constantly changing, it is not obvious beforehand how it will react to QT. The most straight forward way to predict its reaction is to look at recent history.
QT is liquidity neutral when it drains the RRP. Bank reserve levels are unchanged, and non-bank investors have the same level of bank deposits/MMF shares.
Treasury’s 2022Q1 build up of its Treasury General Account (“TGA”) is mechanically similar to QT and was funded almost entirely from the banking sector. Once the debt ceiling was resolved last December, the Treasury increased its balances in the TGA by $600b through debt issuance. That action has a similar effect to QT, except that QT would extinguish the funds rather than leaving them in the TGA. This natural experiment suggests that the financial system as currently configured will accommodate QT by draining bank deposits and reserves (see here for details). Note that the RRP not only did not decline, but actually rose throughout 2022Q1. Leveraged Treasury investors are not increasing their activity, so a smooth QT does not appear likely....
....MUCH MORE
From Mr. Wang's 'About' page:
Previous visits with Fed GuyJoseph spent 5 years studying the plumbing of the financial system as a senior trader on the open markets desk. The Desk sits at the center of the dollar system as its ultimate and infinite provider of dollars. It has access to virtually all regulatory and financial data, as well as open lines of communication with all major market participants. It is one of the few places in the world where one can definitively learn how the system works.
Prior to joining the Desk, Joseph was a credit analyst and in another life he practiced law. He holds a B.A. in Economics from Northwestern University, a J.D. from Columbia Law School, and an MSc. in Financial Economics from Oxford University.
