The Fed Moves To Preserve Liquidity, But Investors Should Remain Cautious (SP500)

Earlier today, the Federal Reserved announced it would keep the Federal funds rate at 5.25% to 5.5%. In the same press release, the Fed announced that it would be reducing the quantitative tightening program, which is the sale of US Treasury securities from $60 billion per month to $25 billion per month starting in June. The sale of agency backed securities was left unchanged. As the Fed steps closer to a rate cut, there are several metrics (other than employment and inflation) that investors should monitor to ensure that the Fed does not have to reverse course.

The Market Reacts to Changes in Quantitative Tightening

Market reaction to the Federal Reserve’s decision to reduce its quantitative tightening was muted. Short-term Treasuries remained flat while 2-year through 5-year maturing Treasuries saw the biggest drop in yields, while the longest duration Treasuries saw more modest yield declines. The December 2024 Fed Fund futures edged up a few basis points, but pointed to a Fed funds rate of over 5% at year’s end. The market did not see the changes in QT as overly bullish despite a brief equity rally.

What’s Quantitative Tightening and How Does it Affect Interest Rates?

Quantitative tightening (QT) is a practice where the Central Bank seeks to mop up excess liquidity in the economy by selling government debt. In the US, the Fed is selling US Treasuries and taking dollars in exchange for the debt. This places downward pressure on money supply growth and attempts to stabilize pricing. A slowing of QT is a signal that the Fed wants to move to a less restrictive policy regime.

At the height of pandemic quantitative easing, the Fed’s total balance sheet reached $9 trillion. Today, it is under $7.5 trillion, meaning the Federal Reserve has pulled $1.5 trillion of money out of the economy in the last two years. There was a brief disruption in the downward trend during the regional banking crisis last spring. The majority of the Fed’s assets are US Treasuries, which were at $5.77 trillion at the height of the pandemic response and have dropped by $1.2 trillion to $4.5 trillion in the last two years.

With the Federal Reserve dumping less US Treasuries onto the open market, it will make it easier for interest rates to fall. The Fed is also getting assistance from the commercial banking sector, which recently resumed buying Treasuries after drawing down their balance sheets for the past two years. Selling fewer Treasuries from the Fed combined with new buying from the commercial banks means higher prices on bonds and lower yields.

Where Should Investors Watch for Problems?

As the Federal Reserve moves toward a less restrictive monetary regime, the possibility of reigniting inflation is a real risk. While inflation and employment are the two main economic indicators monitored by the Fed, there are other statistics which may provide a leading warning that price inflation is about to reignite.

The Money Supply

Changes in the money supply are one of the best leading indicators of inflation. After all, the basic premise of inflation is too much money chasing too few goods. While economists have long monitored M2, I also like to look at currency in circulation. M2 declined on a year-over-year basis throughout 2023 and is making a comeback toward growth in 2024. Currency in circulation seems to show a more stubborn downward growth trend that better mimics inflation. Seeing these two indicators pop could be a sign that price inflation is about to head the wrong way.

Overnight Reverse Repo Activity

The overnight reverse repo facility is where financial institutions park excess cash at the Fed in exchange for interest. It therefore becomes a great measure of excess liquidity in the economy. It’s important for the reverse repo activity to remain under control, where too low can cause cracks to emerge in the financial system and too high can cause price inflation. The facility finally started drawing down in May of 2023 and has gone from $2.2 trillion to just over $400 billion in only a year. With QT changing, investors should watch to make sure the decline in reverse repo activity does not revert.

Liquidity to the Corporate Sector

Investors need to be aware of how banks are lending to the private economy. This can be done by watching the weekly activity in commercial and industrial lending or they can follow a quarterly survey of banks that are identifying as tightening or loosening their commercial and industrial loans. The quarterly survey is nice because it speaks directly to a bank’s outlook. In the last two quarters, banks have headed toward a loosening of lending standards.

Conclusion

Today’s move by the Federal Reserve to reduce the amount of quantitative tightening appears to be more in line with easing concerns around liquidity and the reverse repo markets than about declaring victory over inflation. The Fed maintained the Fed funds rate and renewed its commitment to the 2% inflation target. Despite this, investors should still be mindful of changes in liquidity and money supply as they could reverse course on the fight against inflation.