Still others see the increasingly scarce cash balances that banks hold in reserve accounts at the Fed as the primary cause of the effective rate’s glide higher. And if the central bank’s balance-sheet unwind is already fueling a dearth of liquidity, the problem is only set to get worse.
The Fed is scheduled to shrink its holdings of Treasury and agency debt by as much as $40 billion a month beginning in July. The figure is scheduled to climb to $50 billion starting in October.
As a result of the upward drift in the fed funds rate, several analysts have already begun to re-calibrate expectations for when the runoff will end, especially given stringent post-crisis regulatory requirements that are prompting banks to increasingly hang onto their reserves.
“The liquidity coverage ratio and many other regulations suggest a very high demand, and a very fluctuating demand, for reserves,” said Darrell Duffie, a finance professor at Stanford University. “For the Fed to know exactly how much excess reserves are ​needed to really calibrate the fed effective rate has become very hard in the new regulatory environment.”
Duffie says the era of the small balance sheet has passed. “There is too much demand for reserves now for the Fed to go back.”
Slower Unwind
Sack sees the central bank ultimately slowing the pace of its unwind and maintaining a balance sheet of no less than $3 trillion, from about $4.3 trillion currently.
It sets the stage for a tumultuous second half of the year, one in which market participants are still going to have to navigate additional rate increases, the continued effects of corporate repatriation flows, and ongoing benchmark reforms, the same issues that influenced the short-end in the first half of the year.
“The first quarter of the year was a lot of moving parts,” Credit Suisse’s Pozsar said. “And the rest of the year there is going to be a lot of moving parts, as the Fed is playing around with IOER, there’s tapering and Treasury issuance.”
This article was provided by Bloomberg News.