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This week I had the pleasure of speaking with Andy Constan, CEO of Damped Spring.
Andy has had a storied career at the likes of Bridgewater and Brevan Howard. He possesses a deep understanding of monetary plumbing and how it translates into a tangible impact on the economy and markets.
As mentioned in my piece last week, the FOMC meeting minutes shed light on the future of the Fed’s balance sheet composition and what it wants to see happen next. There’s a ton of complex nuance involved, so I pulled Andy in to break it all down.
Here are a few takeaways from our discussion:
1. QT 2.0
The Fed is trying to plan out what its balance sheet looks like once QT is done. It appears to be rallying around the idea of trying to match the weighted average maturity (WAM) of the Fed’s balance sheet to the WAM of the Treasury’s debt outstanding.
As it stands, the Fed’s balance sheet sits at approximately eight years in duration, whereas the Treasury is at five. Setting aside the complex math that Andy provided, the key takeaway is that QT, in its spirit, is not as done as it may seem on the surface and the market needs to absorb further duration.
I asked Andy why this was important to do, and he mentioned the following:
“Well, let’s just say there was a crisis. In a crisis, bonds rally a lot on the front. Then, say [the Fed] decides to begin QE and let’s assume interest rates are zero as it has said pretty clearly they’re not going to do more QE until interest rates are zero. We’re back in a position where the Fed is buying one and a half percent coupons which — unless the crisis never resolves, it’s going to be underwater on those things and so it would be better, if you’re going to be underwater in those things, you’d rather not have a lot of them going into it.”
2. Debt ceiling dynamics
As the debt ceiling continues on, this has a substantial impact on funding markets due to the associated TGA drawdown that comes with it. The FOMC minutes hinted at the idea of pausing QT to avoid any volatility associated with the debt ceiling drama.
Andy’s explanation:
“QT has two aspects: forcing the private sector to take on riskier assets and draining reserves from the financial system. The first didn’t happen as the Fed used runoff and Treasury muted it with bills. The second — reserve drainage — has been the primary driver of QT’s impact.
Pre-QT, the reverse repo (RRP) grew to over $2 trillion, acting similarly to bank reserves. While RRPs provide liquidity, money market funds don’t lend like banks do. Historically, removing reserves tightened lending due to fractional reserve requirements. But today, reserves aren’t necessary for lending.
QT has drained RRPs without yet affecting bank reserves. The key question is whether reserves remain adequate. Treasury spending during a debt ceiling standoff injects reserves, but once resolved, rapid TGA replenishment could drain reserves too fast, risking financial stress.
This volatility is why some suggest pausing QT, though it’s not a consensus view. If debt ceiling issues resolve, QT may continue unchanged. The Fed sees reserves as still abundant, and I estimate it could withdraw another $250-$500 billion, potentially extending QT into 2026. However, my view remains that it’ll stop at ~$3 trillion in reserves.”
3. Bessent’s Treasury issuance
A few weeks ago, I wrote about how the first QRA meeting from the Treasury gave us a line of sight into how Scott Bessent is thinking about Treasury issuance in contrast to his predecessor, Janet Yellen.
Many expected him to attempt to walk back the bills-heavy issuance strategy that Yellen had implemented, but in reality he kept things as-is. This shocked many observers. However, when I asked Andy about this hypocrisy, he explained how the actual proportion of bill issuance could shift due to a change in the size of the fiscal deficit:
“If they keep coupons the same and the deficit rises…well, they have to make it up with bills and so there’s more bills and the same amount of coupons that’s oversupplying the bills market and undersupplying the coupon market. And so if you’re going to keep it constant, the deficit will determine whether you’re going to be extending the debt. Meaning, if the deficit falls and you keep it constant, you extend the duration you’re terming out the debt. If the deficit rises and you keep coupons constant, you’re relying more on bills.”
Overall, this was one of my favorite interviews of the year. Go check out the full interview and don’t forget your notepad — this one’s a Macro 301 interview.
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