Zhitong Finance has learned that research firm Wrightson ICAP said that as the Fed's reserve outlook becomes increasingly uncertain, the Fed will need to start putting the brakes on the contraction of its balance sheet.
For the past 18 months, the Fed has matured up to $60 billion in U.S. Treasuries and up to $35 billion in agency debt every month. Lou Cranall, an economist at Wrightson ICAP, said a more cautious approach could lead the Fed to slow the pace of quantitative tightening (QT) after its June meeting next year and then reduce the monthly cap on the reduction of US Treasuries to $30 billion in the third quarter of 2024. He expects the mortgage-backed** (MBS) divestiture to continue at the current pace for the time being.
Fed policymakers believe that bank reserves are abundant, and bank reserves are currently at 3$5 trillion. However, a combination of factors, from month-end funding pressures to a mountain of U.S. Treasuries piling up on traders' balance sheets, drove the Secured Overnight Financing Rate (SOFR) to an all-time high last week. These market turmoil underscores the sensitivity of the funding market to bank balance sheets, which in turn highlights the sensitivity of the Fed's own policy program.
It's unclear how long the Fed's quantitative tightening will last.
"The formulated balance sheet scenario that the Fed has discussed over the past few years is based on the assumption that normal dynamics will erode reserves over time," Cranall said in a note on Monday. However, the Fed's balance sheet or front-end dynamics are hardly normal at the moment. ”
The Fed's continued tightening comes as the Fed's overnight reverse repo facility (RRP) has outflowed more than 1$2 trillion. The RRP balance is currently at $839 billion, and the concern is that the Fed will have to stop QT once the tool is emptied.
That's why Wrightson agrees that it's possible that the Fed will choose to stop balance sheet reduction before the RRP is completely depleted. This way, if there is a spike in the funding market, any remaining cash in the instrument can be reallocated to the repo market.
Cranall said the "gradual trajectory" of balance sheet normalization would give the Fed more flexibility and more time to gauge the impact of QT on money markets.