Waning US liquidity pressure set to accelerate in 2024

There's no shortage of challenges on the horizon for the US rates market in 2024. Already the Treasury market has been struggling with liquidity, mostly with getting size done. This is typical when there's been an injection of impactful one-way direction. A gear switch from rate hiking to cutting typically generates jumpy price action, and this is set to be a source of volatility – which is exacerbated by a repo market that has seen better days in terms of size and liquidity. In bonds, tailed auctions, and especially in longer tenors, are another 2023 feature that could persist into 2024. Fiscal deficit-originated supply pressure is also impactful here, making the market a tad skittish, even as the pendulum switches to a rate-cutting bias next year.

The ongoing withdrawal of excess liquidity from the money market is also important to note. The genesis of this is ongoing quantitative tightening (QT) as the Federal Reserve continues to allow US$95bn per month to roll off the curve (and off their balance sheet). The most significant manifestation is to be seen in the fall in idle market cash going back to the Fed on the reverse repo facility. That peaked at around US$2.5tr and is now just below US$1tr, helped recently by a rebuild in Treasury cash balances.

The bottom line here is that these reverse repo balances will head to zero, signalling a virtual end to excess liquidity. As the US Treasury does not need to build additional cash buffers, the pace of fall in reverse repo balances should slow to something akin to the size of monthly quantitative easing – but even at that pace, it would mean the reverse repo balance hitting zero by the third quarter of 2024.

By that time, the Fed is already set to be cutting rates. So, we envisage a period during which the central bank is easing policy through rate cuts and at the same time continuing to engage in QT. While the latter could be construed as being a contrary tightening in policy, the Fed will view it more as a return to more normal conditions in terms of the balance of liquidity in the system. Once the reverse repo balance hits zero, bank (excess) reserves will come under downward pressure. The big question, though, is how far the Fed will push this. Bank reserves are currently flatlining at around US$3.3tr, but have edged higher as of late.

The last time the Fed engaged in quantitative tightening, bank reserves bottomed at a little under US$1.5tr and there was a material effect felt on the money markets. It’s unlikely that we'll get anywhere near that this time around. Bank reserves will certainly get below US$3tr and likely down to US$2.5tr – but it’s unlikely that we'll get much lower, especially as the bias of policy is towards easing. The Fed will want to get liquidity into better balance as a first port of call, but beyond that, it won’t want to over-tighten liquidity conditions. Taking this into account, QT likely ends around the end of 2024.