The balance sheet reduction plan encounters a "political black swan," and the debt ceiling may force the Federal Reserve to urgently halt QT

According to the Zhitong Finance APP, Roberto Perli of the New York Federal Reserve stated that the current debt ceiling impasse could threaten the ongoing balance sheet reduction by the Federal Reserve, causing fluctuations in the central bank's liabilities and, consequently, fluctuations in money market rates.

Once the debt ceiling issue is resolved, the Treasury typically quickly rebuilds its cash reserves—this is the largest liability on the Federal Reserve's balance sheet—leading to a rapid decline in other liabilities. This could particularly affect bank reserves, as the overnight reverse repurchase tool has "essentially been exhausted," Perli said at an event hosted by the New York University Money Market Experts Association.

"The longer the balance sheet reduction continues in the face of the debt ceiling issue, the greater the risk that once the debt ceiling issue is resolved, reserves will rapidly decline to levels that could lead to significant volatility in the money market," Perli stated.

A key Republican in the House indicated on Wednesday that the U.S. could hit the debt ceiling as early as mid-May, earlier than Wall Street strategists had estimated. The U.S. level of outstanding debt reached the statutory limit in January. Since then, the Treasury has been using special accounting strategies and drawing on cash reserves to prevent payment defaults.

For months, officials have rarely publicly indicated when the Federal Reserve might stop reducing its balance sheet, a process known as quantitative tightening, or QT. However, the minutes from the January Federal Open Market Committee meeting showed that policymakers discussed the potential necessity of pausing or slowing this process until legislators reach an agreement on the government debt ceiling.

Repo Pressure

Perli, who is responsible for the System Open Market Account, stated that indicators show that reserve conditions remain ample, but it is currently unclear when reserves might become scarce.

However, Perli acknowledged that pressure in the repo market (a barometer of whether quantitative tightening is excessive) has been gradually increasing, as the share of interbank market transactions above the interest rate on reserve balances has increased, "significantly higher than the same period last year."

Since June 2022, the Federal Reserve has been reducing its debt holdings. Currently, the Federal Reserve allows up to $25 billion in U.S. Treasury securities and $35 billion in mortgage-backed securities to mature each month without reinvesting the returned principal. Initially, the Federal Reserve allowed up to $60 billion in U.S. Treasury securities to flow out of its balance sheet each month, but in June, the pace of the Federal Reserve's debt holdings slowed to this level.

The January meeting minutes also indicated that decision-makers heard reports on potential methods for constructing a secondary market Treasury purchase program after the balance sheet reduction ends. Many officials expressed support for building a purchase program to bring the composition of the portfolio closer to that of outstanding Treasury securities.

Perli noted that currently, the SOMA Treasury portfolio is "significantly underweight" in Treasury bills and "significantly overweight" in coupon securities with maturities of 10 to 22.5 years. He suggested that this discrepancy could be addressed by purchasing Treasury bills in the secondary market, but gradually to avoid impacting the market, although this could take several years Portfolio Composition

Lorie Logan, President of the Dallas Federal Reserve and former SOMA manager, stated last week that in the medium term, it is appropriate for the U.S. central bank to purchase more short-term securities rather than long-term securities, so that its portfolio can more quickly reflect the composition of U.S. Treasury issuance.

"The strategy I just outlined will not lock policymakers into a specific portfolio structure for the long term—it simply shifts the SOMA portfolio to a more balanced composition in the near term," said Perry. "In the future, the committee will be able to flexibly adjust and achieve any desired portfolio composition to best support its policy objectives."

Regarding the standing repo facility, Perry acknowledged that increasing morning operations in the days leading up to the end of the year could help the funding markets close out 2024 relatively smoothly. He also indicated that the New York Fed might provide technical operations at the end of March, which is also a time when the short-term interest rate market tends to be volatile.

According to the latest FOMC minutes, several Federal Reserve officials support finding ways to enhance the effectiveness of the standing repo facility. The New York Fed has been conducting a series of small operations at the start of the trading session