It’s generally agreed upon that in the next six months bank reserves will exceed $3 trillion. Bank reserves are now about $3.3 trillion, so a big change is ahead. The US economy is on the pre-pandemic $30 trillion GDP, the largest in the world. This only furthers underscores how closely connected monetary policy is tied to economic performance.
The Feds tightening monetary policy hard. They are in the process of inflating those reserves away by about $60 billion a month. As bank reserves continue to decline, market participants are watching to see what this will mean for liquidity and financial stability more generally.
Current State of Bank Reserves
Bank reserves have experienced extreme swings during the last several years. Currently, they make up roughly 7.5% of the GDP, still well above historical averages. Bank reserves today are more than 23% of GDP. This number far exceeds the previous record of 27%, which we experienced at the height of the financial crisis in 2009.
Even with the long-term decrease expected, this healthy reserve ratio shows that banks are still sitting on a record buffer. Their current excess liquidity balance is $3.4 trillion. That is a testament to the banks’ robust capital buffers against any foreseeable market disruptions. The reverse repo facility offers a buffer of close to $100 billion. This new layer of security will support financial institutions as they work through these times of transition.
The Federal Reserve’s approach to handling these reserves will be key. QT has been slowly but surely drawing down these excessive reserves. Financial institutions are under intense pressure to rapidly realign their strategies to increase liquidity and prevent disruptions in government money markets. The continuing increase in the required level of reserves will almost certainly have an impact on lending rates and investment practices in all sectors.
Shifts in Government Debt Financing
There are major changes underway in government debt financing. Treasury bills now make up approximately 22 percent of the government’s total debt financing. This would be a significant increase from approximately 15% in FY 2022/23. The growing reliance on Treasury bills indicates a strategic pivot by the government in response to changing economic conditions and investor sentiment.
Compared to this burgeoning cost, the worth of government debt financing has changed with the economy. Just passing by 20 trillion dollars of US GDP in 2022/23. These strategies represent the government’s innovative financing approach to today’s realities and the future economic environment.
Interestingly, market dynamics show an opposite trend for each type of financial instrument. Three-month AA financial commercial paper is trading flat, only a couple of basis points above overnight. This relative stability suggests short-term funding costs have stabilized. Non-financial A2/P2 and AA- ABS have wide spreads by maturity tenor. This shows that market confidence and risk appetite is decidedly not everyone all at once.
Implications for Financial Institutions and Investors
Bank reserves are getting close to the $3 trillion tipping point. It’s time for financial institutions to rethink their approaches to address looming liquidity challenges. The combined effect of shrinking reserves and continuing QT will almost certainly create a bigger whipsaw that presents greater risks and volatility into money markets. It will be up to institutions to continue to be strategic as they fund their day to day activities while investing for the long term.
Investors should pay attention to how these evolutions will alter market dynamics. The risk of increasing interest rates as reserves run out could change the relative appeal of different investment types. As liquidity changes, including due to central bank interventions, and funding costs react, adjustments in asset allocation will be needed.