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Below the Quote on Upcoming Fed purchases: Reserve management, not quantitative easing By Afonso Borges, Fixed Income Research Analyst, Julius Baer

Dollar funding conditions have tightened, raising the prospect that the Fed could reinitiate reserve management purchases. These would be intended to maintain ample reserves and control overnight rates, and should not be understood as an easing of monetary policy.

Dollar funding conditions have tightened in recent weeks. The Secured Overnight Financing Rate (SOFR) recently traded 7bp above the interest rate on reserve balances, while repurchase agreement (repo) rates have become firmer, and Treasury bills (short-term US government securities) have cheapened relative to the Overnight Index Swap (OIS) rate. The pressure reflects a mix of heavier bill issuance, an elevated US Treasury cash balance, shifts in repo volumes, and the Canadian year end. Some of these forces are temporary, but others suggest that reserves are moving closer to the lower end of the Fed’s comfortable range. Overall, the resumption of reserve management purchases appears increasingly likely, potentially before year end. A few firm SOFR fixings (such as those seen last week) are insufficient to move the Fed, but if SOFR trades consistently near the top of the policy corridor, purchases will become likely. The Fed has little reason to test precisely where ample reserves become scarce. The lesson of the September 2019 repo shock was that the boundary is difficult to identify in advance and that crossing it can produce a sudden, nonlinear adjustment in funding markets. Recent Fed communication has placed greater emphasis on preserving control over overnight rates, which reduces the risk of a similar policy mistake. Tighter liquidity is visible in funding markets, but it has not spilled over materially into broader financial conditions, nor should it. Outside episodes in which the Fed misjudges the lowest comfortable level of reserves, fluctuations in bank reserves have generally remained a ‘plumbing’ issue. If purchases resume, they should therefore be understood as reserve management: purchases of Treasury bills designed to keep overnight rates within the target range. They would expand the balance sheet in nominal terms, but would not signal easier monetary policy or an attempt to compress longer-term yields.

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