QT + Lower Federal Outlays = ?

February 12, 2025 | Premium Service |  Update: Last night President Trump sent to the Senate the nominations of Jonathan Gould to be comptroller of the currency and Jonathan McKernan to be director of the C​FPB, ​according to news reports. This is interesting because McKernan reportedly wanted OCC, but is now tasked with the abolition of CFPB. Gould looks like a permanent hire at OCC. Both will easily be confirmed.​And now maybe Fed Gov Miki Bowman goes to FDIC? Opens a Fed governor slot for Trump, who could then appoint that nominee ​Fed chairman. Jerome Powell would remain a governor.

The thundering herd on Wall Street is piling back into all manner of assets, confirming our view that the amount of residual liquidity in the US financial system has essentially forestalled further interest rate cuts. Yesterday Fed Chairman Jerome Powell said that "there is no hurry to adjust interest rates."

Can we have double-digit loan growth in 2025 and still be worried about a recession? Yes we can. But don't make the mistake of thinking that the outlook for the US economy and interest rates is clear cut with President Trump in the White House. Treasury Secretary Scott Bessent may be the only person in the Trump Administration thinking about LT government bond yields. And White House Chief of Staff Susie Wiles has largely eliminated all flow of information to the public about the transition process.

Looking at strong market activity in both the banking system and the bond market in Q1 2025, we can see more possibility of a rate increase later this year than a rate cut. The little hint in that regard is that fact that the Fed is continuing with balance sheet reduction (a/k/a quantitative tightening or QT) despite the earlier protestations about ebbing liquidity from Dallas Fed President Lori Logan.

The first observation to make is that US banks are continuing to shed securities and take losses on COVID era assets. Loans grew less than 1% in Q4 2024, but securities available for sale and in repurchase agreements dropped by double-digits or almost $250 billion. In the near-term, shrinking bank balance sheets may not be a positive for bond yields.

“Wells Fargo's paper losses leapt $13.84B to $48.63B and their 12.13% is the highest since the 15.24% posted in 2023 Q3,” notes Bill Moreland at BankRegData. “We also see they took another $450 Million in Realized Losses from Securities sales.” Overall, bank assets in the US continued to shrink due to the impact of QT, as shown in the table from BankRegData below.

Source: FDIC/BankRegData

The fact that Wells Fargo (WFC) is selling underwater securities means that earnings will improve. The second point, however, is that banks and nonbanks alike are loading up on new-issue loans and securities to boost earnings. Commercial real estate lending surged in Q4 2024, with CBRE’s Lending Momentum Index up 37% year-over-year, driven by abundant capital, strong fundamentals, and increased bank activity, reports CRE Daily.

The lack of Fed rate cuts is not dampening demand for new assets and, indeed, may be encouraging banks and other investors to load up on duration before market rates fall. FOMO is widespread among investors, but will rates fall? Notice in the chart below that bank deposits fell in Q4 as the cash in the Treasury General Account increased.

The million dollar question posed by the chart above: What happens to bank deposits and demand for assets if the Fed continues to shrink the balance sheet and the Trump Administration takes steps to throttle government outlays? As assets run off the Fed’s balance sheet via QT, let us recall, bank deposits disappear 1:1. The Fed’s liquidity model assumes a "normal" cash outlay profile for Treasury, but what happens if President Trump reduces cash outlays in his quest for budget savings? 

Meanwhile, the search for yield by institutional investors is intensifying. Issuance of collateralized mortgage obligations (CMOs) was the highest in four years last month, according to Bank of America (BAC) researchers, driven by a 79% surge in sales of conventional deals from December’s level. With Ginnie Mae issuance jumping 40%, overall CMO issuance was $36.2 billion, the most since February 2021.

“The conventional relative increase as of late largely reflects the subdued bank demand at the moment, as non-bank investors are likely to prefer the spreadier conventional collateral whereas bank investors prefer the superior regulatory treatment offered by Ginnie Mae,” BAC notes.

A final factor in the analysis is the slowdown in securities issuance generally, even with the uptick in CMOs and commercial real estate lending. The surge in issuance in September 2024 is very clearly seen in the data from SIFMA. Notice that US Treasury issuance is falling rapidly and corporate debt issuance in January 2025 was huge. If, as we note above, the Trump Administration reduces federal outlays in 2025, then the relative flow of cash into corporates and other sectors may increase, forcing corporate yields lower. 

With the Fed clearly positioning for no interest rate cuts in 1H 2025, markets are headed into a period of uncertainty when it comes to market yields. Banks continue to show a strong preference for late vintage loans over securities, a fact which may cause loan yields to continue falling in Q1 2025. With the bias of federal spending tending towards lower outlays under President Trump, the markets are already tightening in terms of liquidity and yields.

The political standoff between the FOMC and the White House may result in less liquidity in the markets and a higher probability of a surprise later this year. The Fed is positioning for no changes in the target for federal funds and continued balance sheet shrinkage, meaning that we may actually see a reduction in reserves in 2025. The chart below shows the Treasury TGA in blue, reverse repurchase agreements (RRPs) in red, and the level of total bank reserves in green.

Does the FOMC dare to allow total bank reserves to fall below $3 trillion for the first time since 2021? Will Donald Trump be helpful in this regard? With reverse repurchase agreements near zero and bank deposits set to fall in Q1 2025, the political change underway in Washington may be the source of greater market volatility in the weeks and months ahead. As Chairman Powell told the Senate Banking Committee yesterday, long-term interest rates are high "for reasons not related to Fed policy."

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