Wall Street analysts have been busy war-gaming just how quickly the Federal Reserve might start shrinking its balance sheet. Now attention is also turning to exactly which parts of the financial system it could suck the most liquidity from as it reverses its pandemic-era stimulus.

That matters because it could determine how disruptive the so-called quantitative tightening process is to financial markets as well as how long it might go on for. If and when the Fed starts to shrink its balance sheet—whether by simply not replacing maturing securities  or outright asset sales—there will be an increase in the amount of Treasuries in search of a home. Most of these are likely to be hoovered up by banks or money-market funds, which in turn will need to reduce the amount of cash they have parked in different ways at the Fed in order to purchase them.

If it’s mainly the banks, that could result in a significant drawdown in the amount of reserves that lenders hold with the U.S. monetary authority. Conversely, if it’s money funds, then there will likely be a drop in how much is squirreled away with the Fed’s overnight repurchase agreement facility. Of course, it will likely be a combination of the two, but whether one or the other takes the brunt will be important and is currently being debated by analysts.

It’s also a question that Fed officials, who are meeting this week to decide on their next moves, may struggle to answer, as it depends on how various market players react to the central bank’s policy steps.

A big shift in bank reserves is potentially the more problematic outcome and could curtail how long QT lasts—and how small the Fed balance sheet ultimately gets. If the biggest impact is on the banks, then there is a risk of repeating some of the reserve issues that took place in late 2019 following the last round of quantitative tightening, according to Priya Misra, global head of rates strategy at TD Securities in New York.

Back then, a drop in reserves below the system’s comfortable level helped fuel a disruptive spike in rates on repurchase agreements, a keystone of short-term funding markets. The Federal Reserve has since then implemented additional tools to help reduce potential problems in this area, but a decline in reserves could nevertheless create risks and forestall how much the central bank chooses to shrink its balance sheet.

If bank deposits decline faster than expected, there could also be a mismatch in lenders’ securities portfolios, which might spark more widespread de-risking and result in institutions selling securities at a time when the Fed is also stepping away from the markets.

A reduction in the balance of the so-called RRP, which currently stands near $1.6 trillion, would likely be more benign, and the unwinding process could continue for a while, according to Misra. 

Just where the liquidity drains from then is a key question, and one on which interest-rate strategists are divided:

  • Bank of America Corp. strategist Mark Cabana believes that deposits will lead the drop, citing evidence from what happened after the Treasury Department rebuilt its cash balance in the wake of the most recent federal debt-ceiling imbroglio. While the Treasury amped up bill issuance following the latest Congressional fix, usage of the RRP also increased, climbing to new record highs. Cabana also suggested that when the Fed starts raising rates, banks may be slower to reprice their deposits with so much excess cash, while money-market yields are expected to more rapidly reflect central bank hikes. That said, he believes that a larger Fed QT reserve drain won’t meaningfully drive signs of reserve scarcity until the reduction approaches $2 trillion or $3 trillion.

  • Citigroup Inc. strategist Jason Williams, on the other hand, reckons RRP usage will drop faster, referring to the recent disconnect between the Treasury General Account and reverse repo facility as an “isolated incident.” He also said, however, that if reserves were to fall materially this year and next, there’s an increasing risk that the Fed would have to slow its balance sheet unwind.

  • BNP Paribas SA strategists led by Shahid Ladha wrote in a note Tuesday that the RRP facility offers a large buffer against liquidity tightening. They do not expect reserves scarcity in 2022 or 2023 and that QT should end before scarcity hits. The strategists also noted that the standing repo facility can be modified and other liquidity easing tools enacted as needed.

  • Credit Suisse Group AG strategist Zoltan Pozsar has also explored the potential ways that QT could play out, although he concluded that drawdowns of reserves and the RRP are both equally likely. He also underscored how different this upcoming round of QT might be from the last and said that, unlike last time, the Fed could choose to go beyond simply allowing bonds to roll off to engage in actual outright asset sales.

This article was provided by Bloomberg News.