While we are watching supply and demand and the primary driver for copper, there is another shark in the water - the Fed poilcy. Below is an article from Barrons today that is very analytical and very good, as it illustrate the case for a weakeng dollar this year. This will be a nice tailwiind for copper prices this year.
Nearly every discussion of Federal Reserve policy here elicits letters from readers who ask why more isn’t being made about the reduction of the central bank’s balance sheet—so-called quantitative tightening—while increases in short-term interest rates get all the attention of market participants and analysts.
To give away the ending: The Fed’s QT has had relatively little effect on financial conditions since it got under way last year. And in a surprising twist, the new battle over the nation’s debt limit will largely negate any impact QT might produce. Indeed, hitting the debt ceiling is likely to produce an easing in financial conditions that runs contrary to the Fed’s anti-inflation policies.
This ironic outcome goes against the narrative about the dire consequences of failing to increase the debt limit. But make no mistake, a default on U.S. Treasury obligations, however brief, would be a disaster, effectively undoing the great effort made by Alexander Hamilton to secure the credit of the infant republic.
First, to review, the central bank’s purchases of assets—mostly Treasury and U.S. agency mortgage-backed securities—result in a corresponding increase in liabilities, in this case, mainly bank reserves at the Fed. That produces a monetary expansion as the banks make loans (to use the simplified textbook example). Conversely, selling assets reduces market liquidity.
From $4.1 trillion in February 2020 before the onset of the Covid-19 pandemic, the Fed more than doubled the size of its balance sheet, to nearly $9 trillion by May 2022. This resulted in a roughly equivalent expansion of the M2 money supply, which helps explain the surge in inflation that reached four-decade highs last year.
But since the Fed began QT last year, the effects have been minimal—in stark contrast to the sharp rise in its federal-funds target rate, to 4.25% to 4.5% from virtually zero at the beginning of 2022. Bear with me as I go through the arcane accounting.
Since the start of QT last May, the Fed’s balance sheet has shrunk by $406 billion, Bank of America rate strategists Mark Cabana and Katie Craig wrote in a Jan. 13 research note. On the liabilities side, the Treasury’s general account has fallen by $422 billion, which adds liquidity to the financial system. The logic for this is that outflows from the Treasury’s account represent payments to individuals and businesses, which then likely find their way into deposits.
They also point to two other, largely offsetting effects on the liabilities side. Bank reserves have declined by $273 billion, but money parked at the Fed’s overnight reverse repurchase agreement facility has increased by $234 billion. This RRP balance mainly represents cash placed with the Fed by money-market funds, which earned a higher rate at the facility than on Treasury bills, effectively making them “quasi-reserves.” Other Fed liabilities, mainly currency in circulation, have grown about $55 billion.
The Treasury’s account has been steadily run down as it approached the $31 trillion debt ceiling, which was hit this past Thursday. The BofA strategists forecast Uncle Sam will draw down accounts by $400 billion through August, which will result in corresponding increases in bank reserves and RRP quasi-reserves.
Whatever little restraint exerted by the Fed’s QT will be rendered moot by the debt-limit debate, says Steven Blitz, chief U.S. economist at TS Lombard. With the Treasury running down its account and unable to issue additional securities, liquidity conditions will ease. The markets will have to absorb about half as many Treasuries—roughly an average of $60 billion a month, down from $135 billion a month, and less than they need to buy, he adds. The federal government’s borrowing needs vary seasonally, falling to a low in the second quarter as we render unto Uncle Sam around April 15.
The last debt-ceiling tug of war in 2019 also took place while the Fed was shrinking its balance sheet, Blitz notes. From February through August of that year, the 10-year Treasury yield fell to 1.5% from 2.8%, though QT was slowed and ultimately halted by September as the economy slowed.
Once the debt ceiling is raised, the Treasury will resume borrowing, mainly issuing a large volume of short-term bills, according to the BofA strategists. But the impact will likely be limited; money-market funds will be apt to shift from RRPs to buying newly issued T-bills.
But for now, the real story will be a further easing in financial conditions resulting from a shortage of Treasury securities, which Blitz sees pushing yields down further at the long end of the market. The benchmark 10-year yield already has fallen sharply in the past three months, to 3.4% from 4.25% in late October.
Amid dire predictions about the debt-ceiling fight, and away from the media’s glare on the doings in D.C., financial conditions will be easing further, which would support growth and asset prices while not restraining inflation. That will be in addition to the recent rise in equity prices, the fall in long-term borrowing costs for corporations and mortgages, and the decline in the dollar—just as the Fed aims to tighten financial conditions to bring inflation down further.