: Abundance of cash in the financial system isn’t going away even after the Fed tapers bond purchases


    There’s an abundance of cash floating around the financial system, thanks to the Federal Reserve’s efforts to support the U.S. economy since the outbreak of the pandemic in March of last year.

    And even if the central bank completes tapering of its $120 billion of monthly bond purchases next year, “cash should continue to grow and remain abundant,” JPMorgan Chase & Co. strategists said in a note Friday.

    That’s significant because investors and markets have been operating under the assumption that tapering — or pulling back on the Fed’s quantitative easing — would be a first step toward tightening financial conditions, ahead of the central bank’s decision to hike interest rates. The question on many minds has been if, when, and by how much the Fed might begin pulling back on its purchases– with memories still fresh of the 2013 taper tantrum episode, which led to a spike in long-end yields.

    JPMorgan’s analysis throws cold water on the assumption that tapering alone will be enough to tighten conditions as much as many people think.

    “Even if the Fed finishes tapering next year, the record amount of cash in the system will remain,”  Teresa Ho, one of the note’s authors, said in a follow-up email to MarketWatch.

    Only a contraction of the Fed’s balance sheet would lead to cash levels decreasing and “this is unlikely going to happen any time soon,” she said. Based on that consideration alone, “we don’t foresee any significant tightening in financial conditions when the Fed is finished tapering,” although tightening can still occur through a rate hike.

    Under the Fed’s easy monetary policy, the central bank has been regularly injecting cash into the system through monthly bond purchases — causing its balance sheet to swell by $4 trillion since March 2020 and pushing the amount of reserves in the financial system to record highs.

    Uncertainty around the timing and pace of Fed tapering “means that reserves will likely continue to go up, at least for the next 6-12 months, potentially totaling another $1 trillion,” according to JPMorgan. Ho estimates the current minimum amount of uninvested cash — or “money that literally has left the banking system and has nowhere else to go” — is at just above $950 billion.

    The biggest beneficiaries of the Fed’s QE, in dollar terms, have been bank deposits and money-market funds, according to Ho and strategists Alex Roever and Kabir Caprihan. At some point, though, investors might begin to allocate away from those options and “move into bonds or other high returning asset classes,” they said.

    That matters because it suggests the rally in bonds earlier this week, which sent the 10-year TreasuryBX:TMUBMUSD10Y to its lowest level in almost six months, may have more room to run. But Ho says that’s not necessarily the case because it’s unclear where excess cash that hasn’t already been invested “ultimately reallocates to.” “Much of the cash is institutional, belonging to companies, governments, states and local governments, and other owners, who might decide to spend it as needed. Some may decide to hold onto the excess liquidity in cash. ” 

    Read: Banks to Companies: No More Deposits, Please

    Recent U.S. inflation readings well above 2%, along with a strong July jobs report released Friday, have helped open the door to the notion of a Fed that might be willing to take a more hawkish turn. This week, Dallas Fed President Robert Kaplan told Bloomberg News that the central bank should start tapering its asset purchases sooner rather than later. And Fed Vice Chairman Richard Clarida said he could see himself supporting an announcement to taper bond purchases this year, if the economy evolves as he expects, and enough progress could be made on the central bank’s goals for policy makers to begin raising interest rates in early 2023.

    JPMorgan isn’t alone in concluding that tapering won’t be enough to tighten financial conditions: Senior trader David Petrosinelli of InspereX, an underwriter and distributor of securities, agrees. He adds that “yields are not going to go materially higher with this wall of cash unless Fed officials start to hike rates or the market helps them along by nudging yields higher because there’s a lot of money chasing too few assets.”

    Many institutional investors, such as banks and insurers, “are still sitting on a ton of cash” even after this week’s bond rally, he said, citing anecdotal reports. And the recent runup of inflation has “exacerbated the productive deployment of liquidity balances at banks, insurance companies and other institutional investors,” he said via phone Friday.

    This article was originally published by Marketwatch.com. Read the original article here.

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