Frequent market warning signals! The Federal Reserve's balance sheet reduction "emergency brake" is imminent

According to Zhitong Finance APP, when Federal Reserve policymakers meet next week to decide whether to cut interest rates again, they will also face another increasingly urgent question—when to stop reducing the central bank's $6.6 trillion securities portfolio.

Due to the potential for quantitative tightening (QT) to exacerbate liquidity constraints and trigger market turmoil, the Federal Reserve has slowed the pace of monthly bond holdings reduction earlier this year. However, for several weeks, the money market has sent more warning signals indicating that the quantitative tightening process may have reached its end.

The latest signal is that the reserves in the U.S. banking system fell below $3 trillion this week, marking a decline for the second consecutive week. The level of reserves in the U.S. banking system is a key factor in the Federal Reserve's decision on whether to continue reducing its balance sheet. Data shows that for the week ending October 22, bank reserves decreased by about $59 billion to $2.93 trillion, the lowest level since the week of January 1.

Since the Federal Reserve began reducing its balance sheet in June 2022, over $2 trillion has flowed out of the financial system. This has nearly depleted funds in its primary liquidity indicator—the reverse repurchase agreement (RRP). Meanwhile, a large issuance of short-term debt is attracting more cash into the market.

As a result, various interest rates for short-term borrowing in the interbank market have risen, and tools established to alleviate market pressure have been frequently used over the past week. Even the Federal Reserve's benchmark interest rate—typically seen as less sensitive to liquidity conditions—has risen within its target range for the first time in two years.

In this context, Federal Reserve Chairman Jerome Powell is almost certain to discuss the future direction of the central bank's balance sheet at the meeting on October 28-29. He indicated in a speech two weeks ago that the balance sheet reduction process may end in the coming months.

For many on Wall Street, if the Federal Reserve wants to avoid a repeat of the severe turmoil in the money market in September 2019, it must act quickly. At that time, the Federal Reserve's tightening of its balance sheet led to a spike in short-term interest rates, threatening its control over financing costs and the overall economy.

Mark Cabana, head of U.S. interest rate strategy at Bank of America, stated, "You can definitely argue that the Federal Reserve is not only facing risks—they have actually entered the 'middle ground.' This somewhat echoes 2019, where the Federal Reserve may have over-withdrawn liquidity from the system, and they are well aware of this."

Bank of America and JP Morgan joined the ranks of TD Securities and Wrightson ICAP this week, expecting the Federal Reserve to end quantitative tightening at the October meeting. Several other institutions have also brought forward their predictions for the end date from early next year to December of this year Jason Granet, Chief Investment Officer of BNY Mellon, stated that since Powell's speech, "the issue of the balance sheet has been brought to the forefront." He warned that if the Federal Reserve delays further, "the situation could worsen by the end of the year." Jason Granet said, "They have already seen signs and are prepared to take action. In this case, I think they will choose a relatively cautious stance."

The Federal Reserve decided in April this year to slow down the pace of balance sheet reduction to prevent potential disruptions after the U.S. government raises the debt ceiling in the summer. Since July, the U.S. Treasury has issued a large amount of short-term government bonds to rebuild cash reserves, thereby draining banks' reserves at the Federal Reserve.

The Federal Reserve has long stated that it will stop reducing the balance sheet once bank reserves fall to what is considered a "sufficient" level—the minimum requirement to prevent market turmoil. Federal Reserve Governor Christopher Waller previously estimated that the "sufficient" level is about $2.7 trillion, but he recently hinted that reserves may be approaching that lower limit.

Bank of America strategists pointed out, "Current or higher money market interest rates should signal to the Federal Reserve that reserves are no longer 'ample.' From some indicators, the Federal Reserve may also believe that reserves are no longer 'sufficient.'"

If the balance sheet reduction ends early, the Federal Reserve could repurchase securities to replenish reserves. JPMorgan strategists expect that once quantitative tightening ends, the Federal Reserve will immediately initiate temporary open market operations to alleviate financing pressures around settlement dates and begin regular purchases of short-term government bonds for reserve management in early 2026.

Short-term interest rates have remained stubbornly high recently, even outside of typically volatile key settlement periods such as Treasury auctions or tax payments. Over the past month, the effective federal funds rate (EFFR)—which typically shows little fluctuation during Federal Reserve meeting intervals—has risen three times within the target range. Matthew Raskin, head of U.S. interest rate strategy at Deutsche Bank, noted that in contrast, in 2018, the benchmark rate took months to show such a significant increase.

Mark Cabana stated that based on where the Federal Reserve believes short-term interest rates should be relative to the interest on reserves (IORB), the central bank may need to "replenish" about $150 billion in liquidity. Dallas Federal Reserve President Lorie Logan mentioned in August that the Federal Reserve is monitoring whether market rates stabilize close to or slightly below the IORB level. Although there are differing views within the Federal Reserve on the ideal level of reserves, patience seems to be wearing thin as some rates have already surpassed the IORB JP Morgan's strategist team pointed out that the market turmoil in September 2019 indicated the Federal Reserve's limited tolerance for fluctuations in the federal funds rate and the "money market fund system." The team stated, "If the same mistake is made again, the consequences could be very severe."