How the Federal Reserve will reduce its balance sheet in the future is becoming a focal point of market attention. Morgan Stanley pointed out in its latest research report that changes in the size of the balance sheet may have more far-reaching effects compared to adjustments in policy interest rates, but the entire process will be very slow and there are many technical constraints and market trade-offs.
The report believes that the current balance sheet reduction mainly relies on &#34;passive reduction,&#34; which means not reinvesting in U.S. Treasury bonds and mortgage-backed securities after they mature. This method has already reduced the Fed's assets by more than $2 trillion since 2022 and may continue to be the primary path in the future. However, as reverse repurchase tools are basically exhausted, further balance sheet reduction will increasingly directly reduce bank reserves, which will have a more noticeable impact on the liquidity of the financial system.
The most concerning question for the market is whether balance sheet reduction will push up interest rates. Morgan Stanley's judgment is: not necessarily. The key lies in how the U.S. Treasury issues new debt. If more financing is done through short-term Treasury bills rather than increasing the issuance of long-term interest-bearing Treasury bonds, then the upward pressure on long-term interest rates may be limited.
<h2>Two Paths for Balance Sheet Reduction: Passive Maturity and Active Sale</h2>
The report points out that the Federal Reserve has two main ways to reduce its balance sheet: one is passive reduction, which means not reinvesting after securities mature; the other is actively selling assets in the market.
Currently, passive reduction remains the most realistic path. Actively selling assets, especially MBS, is quite challenging because it may lead to widening spreads and further worsen housing affordability. Therefore, the threshold for the Fed to actively sell MBS is very high.
At the current pace, it may take nearly ten years for the Fed's MBS holdings to be reduced by half, indicating that the balance sheet reduction process itself will be very slow.
<h2>The Real Constraint: Bank Reserves and Liquidity</h2>
The key limitation for further balance sheet reduction does not lie on the asset side but on the liability side.
As the scale of reverse repos decreases, future balance sheet shrinkage will increasingly depend on the decline of bank reserves. However, banks have a strong demand for reserves, such as regulatory requirements like the Liquidity Coverage Ratio (LCR) and internal liquidity management rules.
If reserves decline significantly, liquidity conditions in the financing market may tighten, and the volatility of the federal funds rate and repo rates may increase, potentially exceeding the reserve interest rate. To prevent significant fluctuations in market interest rates, the Fed may need to use more temporary open market operations to adjust liquidity.
<h2>A Technical Solution: Shrink the Balance Sheet Without Reducing Reserves</h2>
The report also proposes a technical possibility: to shrink the balance sheet through coordination between the Treasury and the Federal Reserve without reducing bank reserves.
For example, the Treasury could lower its balance in the Federal Reserve's General Account (TGA). If the TGA scale decreases, the Fed can reduce its holdings of U.S. Treasury bonds by the corresponding amount, thereby shrinking the balance sheet while keeping bank system reserves unchanged.
This method may also reduce the interest expenses the Treasury pays to the Fed, but it requires a high degree of policy coordination.
<h2>Will Balance Sheet Reduction Push Up Long-Term Interest Rates? The Key Lies with the Treasury</h2>
The market is generally concerned that balance sheet reduction means an increase in bond supply, which would push up yields, especially long-term rates. However, the report suggests that this relationship is not necessarily the case.
If the balance sheet reduction is achieved through passive maturities, then the new supply is actually completed through the refinancing by the Treasury, and the maturity structure of government bonds is determined by the Treasury, not the Federal Reserve.
If the Treasury continues to favor issuing short-term Treasury bills rather than expanding long-term bond issuance, then the long-term bond supply that the market needs to absorb will not significantly increase, and the upward pressure on long-term rates may also be limited.
Overall, the Federal Reserve's balance sheet reduction is technically feasible, but the process will proceed slowly and will be constrained by multiple factors such as bank reserve demand, market liquidity, and the Treasury's debt issuance structure. For the market, what is truly worth paying attention to is not only the balance sheet reduction itself but also the changes in liquidity environment and interest rate structure during the process.
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The Federal Reserve's approach to reducing its balance sheet mainly involves passive reduction and active sales. Morgan Stanley points out that the process of balance sheet reduction will be slow and subject to technical constraints. Passive reduction is the primary path, having decreased by more than $2 trillion since 2022. The market is concerned whether the balance sheet reduction will drive up interest rates, and Morgan Stanley believes the key lies in the method of new debt issuance. Further balance sheet reduction will depend on a decline in bank reserves, which may affect liquidity in the financial system

- The market is closely monitoring how the Federal Reserve will reduce its balance sheet, which could have profound effects.  
- Morgan Stanley highlights that the current strategy relies primarily on "passive reduction," allowing securities to mature without reinvestment, which has already decreased assets significantly since 2022.  
- Future balance sheet reduction may face challenges from declining bank reserves, impacting liquidity; however, coordination with the Treasury could enable reduction without affecting reserves, limiting upward pressure on long-term interest rates.

How significant is the impact of the Federal Reserve's balance sheet reduction?