The Road Ahead: When Will the Fed End Quantitative Tightening and What Could It Mean for the Crypto Market?

Introduction

In December 2024, the Federal Reserve’s total assets dropped to approximately $6.8 trillion, nearing its quantitative tightening (QT) target. As the Fed approaches the end of QT and potentially pivots toward quantitative easing (QE), what might these policy shifts mean for the crypto market? This article systematically analyzes three key aspects: the lessons learned from previous episodes of QT and QE, the four core factors influencing the Fed’s policy decisions, and the relationship between changes in Fed policy and crypto market cap.

1. Liquidity Crises and “Unlimited QE”: Lessons from Past QT and QE Episodes

1.1 The 2019 Repo Market Liquidity Crisis

The Federal Reserve began raising rates in December 2015 and initiated QT in October 2017. However, by mid-2019, mild liquidity risks emerged, prompting the Fed to implement its first rate cut since 2008 in July 2019. Despite this, overnight repo demand surged in September 2019, pushing repo rates above the upper bound of the Fed’s target rate range.

To stabilize financial markets, the Fed intervened by: 1) resuming Treasury purchases, 2) increasing the frequency and size of overnight and term repo operations and 3) cutting rates twice in quick succession (September and October 2019). These measures effectively ended QT and marked the resumption of QE.

Despite the Fed cut rates in July 2019, it still failed to aviod the repo market liquidity crisis, and was later criticized for policy constraints and questioned for its independence. The Fed also realized that under Ample Reserve Framework, the relationship between policy interest rates and reserves has weakened. The Fed then needs multiple factors to assess market conditions and the potential risks of over-tightening.

1.2 2020’s “Unlimited QE”

The COVID-19 pandemic in early 2020 triggered unprecedented economic disruptions, including sharp declines in employment and consumption. To address mounting financial risks, the Fed slashed interest rates to zero, launched a new QE program with no purchase cap, buying US Treasuries and mortgage-backed securities (MBS), and deployed a variety of liquidity tools to stabilize markets.

However, these policies also brought unintended consequences, such as reduced monetary policy flexibility, inflated real estate bubbles, and heightened inflationary pressures. These side effects eventually forced the Fed to adopt a more hawkish stance later.

1.3 Delayed Ending QT vs. Blindly Initiating QE: Reflections on Two Actions

The 2019 liquidity crisis highlighted the Fed’s delayed response in determining the appropriate timing to end QT, while the 2020 pandemic response revealed the Fed’s tendency to act blindly according to current economic situations rather than future outlook. Since announcing the current round of QT in June 2022, the Fed has operated in an orderly manner based on risk control and ensuring ample reserve, and avoids huge market fluctuations caused by blind or disorderly policies. Under such forward-looking and preventive guidelines, the Fed now pays more attention to guiding market expectations and will test market reactions through a series of “micro operations”.

The QT’s goal is to reduce the excess assets and liquidity accumulated during QE while controlling the interest rate declines to ultimately control the yield curve. Policymakers including Powell, Williams, and Logan have emphasized that rate cuts and QT are independent processes. By maintaining the trend of approaching neutral rates and using QT, the Fed aims to increase its monetary policy flexibility and save space for future actions.

2. Four Key Factors Indicating QT Nearing Its End

It is particularly important to analyze the potential actions of the Fed in halting QT or starting QE from four aspects: ON RRP, BTFP, SOFR-IORB Spread, and the ratio of total reserve to total bank assets.

2.1 Overnight Reverse Repurchase Agreements (ON RRP)

The overnight reverse repurchase agreement (ON RRP) facility is a key component of the Fed’s liabilities, with major participants including primary dealers, money market funds, banks, Federal Home Loan Banks, and government-sponsored enterprises like Fannie Mae and Freddie Mac. Among these, money market funds are the main players. When these non-bank institutions have excess funds but limited investment opportunities, they turn to the Fed to earn a low but secure reverse repo rate. However, since mid 2023, these institutions have been withdrawing deposits to purchase U.S. Treasuries, which leads to a continuous decline in ON RRP balances.

Once the ON RRP is exhausted, further QT will directly deplete reserves. The Fed is likely to halt or slow QT when reserves approach a level slightly above the “ample reserves” threshold. As of now, the ON RRP balance has dropped to approximately $268.7 bn, marking a nearly 90% decline from its December 2022 peak. Given the ongoing decline in ON RRP balances, it is reasonable to assume that the Fed may already be discussing whether to stop QT or even consider modest QE.

2.2 Bank Term Funding Program (BTFP)

The Bank Term Funding Program (BTFP) was introduced by the Fed in March 2023 to address risks posed by regional/small and medium banks, offering one-year loans. Since reserves yield and bond yield are higher than the BTFP rate, banks have had arbitrage opportunities. However, as the program is set to expire in March 2024, the shrinking BTFP balance has accelerated the pace of the Fed’s asset reductions. Once the BTFP program concludes, banks will no longer have access to cheap arbitrage funds from the Fed, which could slow the pace of QT.

On the other hand, if liquidity pressures rise, the Fed is likely to remain cautious about fully restarting QE in the current high-inflation environment. Instead, it may opt for alternative liquidity tools, such as reopening the BTFP or similar programs, to facilitate modest QE.

2.3 SOFR-IORB Spread

Fluctuations in market interest rates can directly reflect reserves adequacy. When reserves become insufficient, banks will be more cautious in liquidity management, which will drive up money market rates. The Secured Overnight Financing Rate (SOFR), which is based on overnight repo transactions collateralized by US Treasuries, is particularly sensitive to liquidity pressures. Historically, significant spikes in the spread between SOFR and the Interest on Reserve Balances (IORB) rate during 2019 indicated tight market liquidity conditions.

Since 2021, the SOFR-IORB spread has consistently hovered around -0.1%. However, starting in Q4 2023, the spread has experienced constant upward spikes, reaching +0.15% and +0.13% in October and December 2024. This could signal insufficient reserves in the US banking system, especially considering that the BTFP program is nearing its end and its impact on Treasury market liquidity has diminished. The observed volatility in the SOFR-IORB spread is increasingly likely to stem from the internal liquidity and reserve levels of the banking system.

2.4 Reserve Adequacy Levels

Reserve adequacy is a core metric for determining when the Fed might stop QT. If the Fed opts to stop QT or modestly expand its balance sheet, it can then maintain an “ample reserve” level to preemptively offset pressures from bond issuance in Q1 2025. According to the New York Fed chairman, the reserve demand curve is non-linear, and reserve adequacy can be measured as the ratio of total reserve to total bank assets. The boundary between “abundant reserves” and “ample reserves” lies at 12%-13%, while the boundary between “ample reserves” and “scarcity” is at around 8%-10%.

The chart below illustrates that in March 2019, when the Fed announced a slowdown in QT, this reserve-to-asset ratio had already fallen to around 9.5%, and it subsequently dropped to a low point in September 2019. Since the Fed began the current round of QT in June 2022, the reserve-to-asset ratio has been maintained between 13% and 15%, but it has gradually declined to its current level since early 2024. If the Fed decides to halt QT when reserves approach the “ample” threshold, further observations will focus on whether the reserve-to-asset ratio falls below the 13% or even 12% threshold.

2.5 Summary

Analyzing ON RRP, BTFP, the SOFR-IORB Spread, and the reserve-to-asset ratio reveals that: the buffers the Fed has used to mitigate the impact of QT, namely ON RRP and BTFP, have significantly shrunk. Further QT would deplete reserves and push the reserve-to-asset ratio closer to the 12%-13% range. Meanwhile, declining reserves would drive up market interest rates, widening the SOFR-IORB spread and further prompting the Fed to halt QT or even modestly deploy QE. The broader macroeconomic environment is steadily moving toward a scenario where stopping QT and initiating QE becomes more likely.

When determining the critical timing for halting QT or beginning QE, the reserve-to-asset ratio and movements in the SOFR-IORB spread should be closely observed. If the SOFR-IORB spread continues to spike even under “ample reserve” conditions, it may signal an urgent need for “corrective” action. Given the lagging impact of policy decisions (e.g., the liquidity crisis occurred just 6 months after the Fed slowed QT in March 2019, it only exerted limited influence in easing pressure), from a prudent perspective, it might be possible that the Fed initiating discussions in January, outlining a roadmap to halt QT in March, and implementing policy changes between May and July.

3. The Impact of Fed’s QT/QE Policy Changes on Crypto Market

3.1 Financial Liquidity Indicator: A Barometer of the Fed’s Market Influence

The Federal Reserve’s influence on financial system liquidity primarily stems from three sources: securities held or loans extended by the Fed, the Treasury General Account (TGA), and the ON RRP facility. Since an increase in the TGA or ON RRP shows liquidity withdrawal and a decrease represents liquidity injection, the result of “Fed liabilities — TGA — ON RRP” can be used as an indicator of US financial system liquidity, This liquidity indicator closely tracks the movement of bank reserves.

3.2 Financial Liquidity Indicator vs. Total Crypto Market Cap

When comparing the financial liquidity indicator (adjusted forward by 6 months) with the overall crypto market cap, a strong correlation can be observed from the onset of QE in 2020 through the end of 2021. However, a significant divergence emerged thereafter.

On one hand, the cryptocurrency market’s performance is influenced not only by macro policies but also by its own unique factors, such as technological advancements, evolving applications, and Bitcoin halving dynamics which provide additional momentum. On the other hand, in 2022, the crypto market faced a series of shocks, including DeFi hacks, the collapse of Terra, the arrest of Tornado Cash developers, a sharp decline in ASIC mining rig prices, and the FTX bankruptcy, all of which drove market capitalization downward.

Since 2024, however, a combination of political factors and the introduction of crypto ETFs has played a stabilizing and uplifting role in overall crypto market cap. Meanwhile, despite the Fed continuing along a QT trajectory, the resilience of the US economy and expectations around monetary policy have, to some extent, mitigated concerns over the reduction in reserves.

3.3 Insights from the Financial Liquidity Indicator and Crypto Market Cap

The relationship between the financial liquidity indicator and the overall crypto market cap offers several key takeaways:

1. The Lagged Response of Cryptocurrencies to QE:

After the start of QE in early 2020, the crypto market only began its upward trend in the second half of 2020, with a lag of over 6 months. This delay can be attributed to the time it took for liquidity to reach the relatively niche crypto market at that time, as well as market shifts driven by innovations like DeFi Summer. In the future, as financial channels into the crypto ecosystem become more established, crypto market is expected to respond more quickly to liquidity injections from QE. The lag time between QE and crypto market cap changes is likely to shorten significantly.

2. The Influence of Policy Expectations:

After repeatedly delaying responses to actual market demand, the Fed has increasingly focused on managing market expectations. For instance, after Powell’s hawkish speech in December, crypto market cap dropped significantly, even though the Fed had already slowed the pace of QT. In the future, changes in expectations regarding QT/QE policies will likely have a more immediate and pronounced impact on the crypto market, even if the additional liquidity does not directly flow into crypto (particularly altcoins) right away.

3. Market Sentiment and Risk Appetite Shifts:

One major factor behind the divergence between crypto market trends and reserve levels beginning in 2023 is the rise in risk appetite. Given the background of a global economic recovery, demand for risk assets like crypto and stocks has remained strong despite the reserves decline. However, caution is warranted regarding the impact of future shifts in US economic indicators on crypto trends. If the probability of a “hard landing” for the US economy increases, crypto could then face downward pressure from negative factors, even in a scenario where reserves rise or the Fed transitions to QE.

4. Summary

Overall, whether or not the Fed will choose to halt QT and initiate moderate QE will depend on the adequacy of reserves and the market’s demand for liquidity. By closely monitoring these indicators, it is possible to anticipate the Fed’s future policy trajectory. Given the declining reserve levels and a widening SOFR-IORB spread, the Fed may already be considering the prospect of halting QT or even modestly starting QE.

Compared to four years ago, the crypto market is now more closely connected to institutional funding channels through ETFs, stablecoins, and a diversified range of RWA products. As a result, changes in the Fed’s policies are likely to lead to more timely and rapid responses from the crypto market. However, given that the crypto market’s performance does not entirely align with the liquidity conditions of the US financial system, it is also crucial to pay attention to economic data and uncertainties from forthcoming fiscal policies. All these factors will play a key role in shaping market dynamics, offering opportunities to identify new breakthroughs amid volatility.

About Gate Ventures

Gate Ventures, the venture capital arm of Gate.io, is focused on investments in decentralized infrastructure, middleware, and applications that will reshape the world in the Web 3.0 age. Working with industry leaders across the globe, Gate Ventures helps promising teams and startups that possess the ideas and capabilities needed to redefine social and financial interactions.

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