While markets are parsing through central bank communication for the timing and pace of rate cuts, the future of central bank balance sheets is increasingly in focus as well. What will happen with quantitative tightening? And what will balance sheets look like in a future steady state?

Participants:

• Simon Deeley (Desk Strategy), Canada Rates Strategist
• Blake Gwinn (Desk Strategy), Head of US Rates Strategy
• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• Robert Thompson (Research), Australia Macro Rates Strategist

Research Analyst opinions are their published views, independent of those expressed by Desk Analysts

Jason Daw:

Hello. And welcome to Macro Minutes. During each episode, we'll be joined by RBC capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.

Simon Deeley:

Welcome to the March 19th edition of Macro Minutes, entitled the Right Balance Sheet.

I'm your host, Simon Deeley. It is a thematic one, this time. While markets are parsing through Central Bank communication for the timing and pace of rate cuts, the future of Central Bank balance sheets is increasingly in focus, as well. What will happen with quantitative tightening, and what will balance sheets look like in a future steady state? We are fortunate to have RBC experts from across the world to provide insights on the situation in their respective regions.

I will kick off on the BOC situation, what we expect from a key speech on March 21st. Blake Gwinn follows on the Fed's balance sheet and meeting this week. Peter Schaffrik will discuss the European experiences. And Rob Thompson will finish with a look in on the RBA.

Aided by a large spike in links balances, which is the BOC's equivalent of reserves, on February 19th, CORRA turned back lower, and has set at 5.01, despite links balances coming back down to recent lows. So, there are 100 billion as of yesterday. If CORRA continues to set within one to two basis points of target, then we think it is unlikely the BOC will end QT at one of the next two meetings.

The key April 1 maturity, which is 23 billion maturing from the BOC's assets, 37 billion in total, is already manageable given the high GOC cash balance, currently. As long as that cash balance does not spike higher, subsequently, links balances should remain close to 100 billion in the following months, and an announced end to QT now looks more likely sometime in Q3.

To be clear, GOC bonds are likely to form the majority of BOC assets for some time now, indeed about 120 billion matures in 2030, or later, anyway. But purchase levels are likely to be below the 13% of bond auctions that they were buying, pre-pandemic.

Treasury bills have not been on the balance sheet for almost two years now. With the pending end of bankers acceptances in the money market, and expected announcement of a new one-month GOC bill maturity, suggesting to us that bill purchases will not start immediately, instead the focus will likely be on keeping supply supported at the very front end. Bill purchases could potentially return at a later date, though.

That's the situation in Canada. And over to Blake, now, to discuss the Fed.

Blake Gwinn:

Yeah, thanks Simon.

One is that most FMC participants at this point seem to be leaning very hawkish on the balance sheet. Most of the comments we've gotten from them really suggest that they want to return to the lowest possible balance sheet size. It's still going to allow them to effectively manage interest rate policy. They really don't seem to be afraid of letting a little bit of volatility in funding markets get in the way of that.

We do wonder if those are the wrong starting point to be estimating the new lower bound for reserves. I think a lot of what happened in September, 2019 in repo markets was related to balance sheet tightness and rigidity, just as much if not more than it was due to a low level of reserves. And if that's the case, if you don't have those balance sheet pressures this time around, it's possible reserves could actually go lower, again, in terms of percentage of GDP or bank balance sheets. It's possible they could push even lower than many of us are expecting. So, that's definitely a risk I think, that this actually could run longer than we expect.

The last thing I would say is that one of the reasons I think a lot of people had been expecting that balance sheet wind down may be cut a little short in the US is that there are some distributional issues, meaning that a lot of the reserves in the system have seemed to be stuck at very large money-center type banks. They have big piles of excess, but at the same time some medium smaller sized banks might be seeing shortages in terms of the level of reserves that they want to hold. So, even though the total number, the aggregate number, of the whole system might still seem optically large, if you have this clumping it at some banks where they have a lot of excess and it's not really getting to those smaller, medium-sized banks, it could cause stress earlier than many are expecting.

But I do think, if they follow this plan, we expect where they slow the pace and move over a longer period of time, we agree with Dallas Fed President, Lorie Logan, who said that slowing it down like this could allow some redistribution of those reserves from the haves to the have-nots to happen a little bit more naturally. So again, that's something, if they do slow down that pace, could extend the amount of time that they're able to do QT, and make sure that we don't see localized shortages in the way I was just describing.

A few more real quick points on QT I just wanted to make. We wrote about a lot of these things in a piece we put out several weeks ago, but we see essentially no link between the Fed's QT decisions and rate policy. It's entirely a function of what's happening at funding markets. It's not going to be driven, whether they're cutting or not cutting rates. Those two decisions are going to be completely independent of each other. The other thing I would say is that the market impacts of what the Fed does with QT we see as really isolated to front-end rates. And we think the impact to other asset markets is, a lot of times, very much overstated. Again, we put out a piece recently on that that walks through some of the reasons why those linkages aren't that strong. But overall we don't see what the Fed does with QT as a big driver of risk assets, and see that link between reserve levels and overnight RP levels, and things like equities and credit markets, and even lending activity by banks, CapEx, et cetera. We just see very weak links, there.

Lastly, I just want to note, turning things around to this week's FMC meeting, Powell has promised that they are going to kick off a more in-depth discussion on the balance sheet at this meeting, so we'll probably see some headlines coming out of the meeting, as Powell is very likely to be asked about that. Specifically, we do think the press is probably likely to ask him about some comments that both he and Waller made recently on the composition of the balance sheet.

Similar to what Simon was talking about, there has been some discussion around what the Fed's balance sheet's going to look like from a compositional standpoint, Waller suggesting that there may be a preference to hold more short-term securities bills rather than long-dated coupons. The most obvious benefit of this is that they don't have this mismatch between their interest expense and interest income that causes these operating losses we've seen over the last year. If they're holding very short data securities, those rates will float very much like the rate they're paying out on reserves. We wouldn't be surprised to see Powell get asked about that. But we don't think he's going to have any concrete decisions. This discussion is just kicking off at this meeting, and we think it'll carry on for a few more meetings before they really reach any kind of major conclusions. And even then, compositional decisions on the balance sheet really don't have an impact until the Fed ends QT.

Simon Deeley:

Thanks Blake. Now, over to Peter on the ECB and BOE.

Peter Schaffrik:

Thank you, Simon.

This, for me, is a very timely and pertinent podcast. And the reason is because just last week the ECB has concluded its strategic review, where this precise topic has been the agenda, how would they steer the balance sheet going forward? And basically the question before them was, would they do it more or less as Blake just described, essentially through the bond portfolio, or would they do it more in the way that the Bank of England has suggested that they want to do it, where is they reduce the bond portfolio beyond the level where reserves switch over from being ample to being scarce, and then provide the difference through lending operations, and thereby making the ultimate guiding rate in the market the lending rate, again, how it was before QE started, way back when.

In the end, they have decided to follow the Bank of England's blueprint and have said that they want to reduce the bond portfolio whilst maintaining a strategic bond portfolio in the long term, but reduce the bond portfolio two levels, where they will also provide liquidity through lending operations, once more.

They have specified that they will do this through the current tools that they have, two-week and three-month operations, but have also said that they will provide some form of a longer tenor on these lending operations, at some point in the future.

Now having said all that, and I think this is true for the Bank of England who has already said how they want to do it, as for the ECB who have just specified how they want to do it, what are the parameters of this and what does it mean for the market? Now, Blake has discussed that for the Fed, or for the market in the US, it's unclear where this cutoff point actually is, where reserves cross over from being ample in circulation to being scarce. And the same is obviously true for both the sterling market as well as for the Euro market, and mainly because we haven't been in that situation for more than a decade. And also, the regulatory framework, and frankly the natural demand for reserves from commercial banks, has changed quite dramatically. So, we don't really know where these cutoff points are.

There are some surveys around, and they indicate in the sterling market that it's somewhere between 325 to 480 billion. For the Euro market, it's around about 1.5 to about 2.2 trillion. These are very wide ranges. But the other thing is they're also very far away. Currently, the outstanding provision of reserves to bond portfolio and lending operations in the form of TFSME in the sterling case is 730 and 150 billion, respectively, so that's close to 900 billion still. And in the case of the ECB, we have reserve provision of around about 3.7 trillion, still. So we are very, very far away from wherever these cutoff points are. This then begs the question, how long does it take if they start or they have started QT already, if they conduct QT, let's say at the current pace or in the case of the ECB, at a sped-up pace from the middle of the year onwards, how long does it take until we get there?

However, I want to make a point that I think is probably sometimes forgotten. That does not mean that, at this stage, bond QT is already going to end. Because neither of the central banks have actually specified how large the structural bond portfolio that they intend to hold will be. That could be 50 billion, could be 100, could be 300, or could be even more. We just do not know. And I think they will provide guidance, at some unspecified point in the future, but we estimate that probably bond QT will be going on for another four or five years, from here onwards. So, that's about another two years after these cutoff points have been reached. We'll very likely end up in a situation where net bonds that the market has to buy that come off and roll off the bank's balance sheet will be continuing way beyond the point where the central banks also start providing liquidity through these repo operations that I have just mentioned.

Now, last but not least, I think, for the ECB in particular, it is important to note that this has also had the consequence of them collapsing the corridor, whereas the Fed and the Bank of England already are operating, more or less, a single interest rate, not quite for the Fed, but certainly true for the Bank of England. The ECB has been operating a corridor that was quite wide, with the gap between the so-called deposit rate and the refinancing rate, being 50 basis points. They have collapsed that to 15 basis points in order to not have too wide fluctuations in the money market rates, in the eventuality that we come to the point where lending will be the main driver of money market rates, once more.

I think that hopefully gives a good overview. We certainly have written about the topic. And we're very happy to provide more information for clients, if they're interested.

Simon Deeley:

Great stuff, Peter. Last but not least, we go to Rob on the RBA.

Rob Thompson:

Thanks, Simon. And hello from Australia.

We've just had an RBA meeting today, which I'll cover. But keeping to the theme of today's podcast, I'll dispense with the balance sheet angle first. At the moment, the RBA remains in passive rundown mode, in contrast to elsewhere in the world where nowhere close to the stage where QT taper is even being discussed. In fact, the next possible development in our market is quite the opposite. We're looking at the possibility of an accelerated QT schedule in the second half of this year, involving active bond sales, as we've already seen implemented by the RBNZ, Bank of England, and Ritz Banc.

First though, the bank wants to see just how markets tolerate the next tranche of cheap Covid-era emergency loan facility paybacks by the commercial banks. There's just under 100 billion of this to come by the end of June, which, in combination with some maturing bond holdings should see the RBA balance sheet shrink from around 22% of GDP at present to around 17% by mid-year, which would be towards the lower side of the range we see elsewhere in the world.

There'll still be plenty of liquidity in the system, though, so we're not expecting any particular ill effects. The last big paybacks in the third quarter of last year seemed to go pretty smoothly. There was some increase in fronting spreads at the time, but it's ultimately proved temporary. So, while we're looking forward to the act of QT debate to kick up later in this calendar year, for now we're much more focused on policy rate moves than the balance sheet.

Moving over then, to a quick review of today's events. The board kept rates unchanged at for 35% as expected, but the statement earned dovish with the further watering down of what had already been a pretty mild hawkish bias in the last Feb statement. Tweaks made today on inflation, the health of the consumer, and wages, all added to this dovish picture, and a key line from February that a further increase in interest rates cannot be ruled out was removed.

There wasn't much of that in the labor market, but we think that's largely because seasonality has become a bit difficult to look through, around Jan and Feb. The board likely wants a few more months of data before saying too much on that. Markets were quick to react, though, nonetheless, and certainly agreed with our dovish assessment, curves full steepened, bond yields moved about five to eight basis points lower, and market pricing for cuts this year increased from around 37 basis points, pre-meeting, to 44 post. Would note, though, that Bank of Japan headlines started hitting about five minutes after the RBA rate decision, though, so we'd caution some of the additional rally in fixed income stemmed from price action post that.

Looking ahead for Australia, we're starting to focus a bit more on the labor market, despite not getting much on the topic today, and downside growth risks in Australia, we think labor markets in particular could be a key point of concern in the coming months. Indeed, we've had a weaker set of forecasts for unemployment ourselves this year versus the RBA, for quite some time. So, it'll be interesting to see when that starts to come over to the frame.

This is tilting us towards seeing some decent value in Australian fixed income, as upside risks to the cash rate appear to be dissipating, and downside risks perhaps starting to emerge just a little bit more.

Simon Deeley:

Excellent. Thanks very much, Rob.

That wraps up this edition of Macro Minutes. Thanks for listening. We'll be back in two weeks time.

Announcer 2:

This content is based on information available at the time it was recorded, and is for informational purposes only. It is not an offer to buy or sell, or a solicitation, and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.