Money Market Magic Masked Fed's QT Bite So Far, but 2024 Promises Different Tune

investing.com:

The Fed has been running QT for a while and yet there is still abundant liquidity in the financial system.

Fed’s bond holdings are down $1.3 trillion from their peak (due to QT), yet only half of this supposed tightening has impacted bank reserves (aka liquidity) which are down a meager $0.7 trillion.

This ongoing «money mystery» has caught many off-guard, and it has helped fuel several bullish narratives: the most famous one being that higher ‘’liquidity’’ has supported stock markets in 2023.

2024 is shaping to be another year where monetary plumbing will matter a great deal.

To understand the mechanics behind this money mystery, let’s start from QT.

Here are 5 simple steps to understand how Quantitative Tightening works:

Step 1-2: the Fed doesn’t reinvest maturing bonds (1) from its QE portfolio (= performs passive QT) and therefore destroys reserves (2) — also known as «liquidity»;

Step 3-5: the government needs to roll over its funding, but the Fed isn’t rolling over its bond holdings (3).

Banks now need to step up and absorb more of the newly issued securities (4-5).

The resulting balance sheet changes are summarized in the bottom tables: the Fed reduces its balance sheet by 100 which sees a 1:1 reduction in reserves (aka ‘’liquidity’’) as banks must step up to absorb bond issuance.

This is how QT normally works.

Yet something different is happening this time.

Back in 2021, the Fed had an issue: rates were at 0%, and there was too much money in the system.

Money Market Funds (MMF) were bidding up T-Bills so much that yields were testing negative levels (!), and so to stabilize money market rates the Fed proposed a friendly alternative: the Reverse Repo Facility (RRP).

This encouraged MMF to park money at the Fed,