Federal Reserve Governor Waller's reserve forecast questioned, Wall Street warns of liquidity crisis
Wall Street strategists question Federal Reserve Governor Waller's forecast on reserves, believing his estimates are too low. Waller mentioned that reserves could drop to $2.7 trillion, while the current amount is $3.34 trillion. Strategists from JP Morgan and Citigroup pointed out that reserves might fall to $2.8 trillion by the end of the year, and the market is focused on the Federal Reserve's cash reserves to determine the timing of balance sheet contraction. Analysts warn that the risk of a liquidity crisis may increase due to the Treasury withdrawing excess liquidity
According to the Zhitong Finance APP, Wall Street strategists believe that the forecasted figure for the adequate reserves needed in the financial system to prevent systemic chaos, as indicated by Federal Reserve Governor Christopher Waller, should be higher. Waller stated last week that the Federal Reserve could reduce bank reserves to about $2.7 trillion, while the current level is approximately $3.34 trillion, which would allow the Federal Reserve to continue shrinking its balance sheet, a process known as "quantitative tightening."
JPMorgan Chase strategists indicated that this week, the level of reserves deemed "adequate" without disrupting the overnight funding market may need to be raised. Citigroup Global Markets strategists Jason Williams and Alejandra Vazquez expressed on Monday that reserves could decrease to $2.8 trillion by the end of the year.
Market participants are closely monitoring the cash reserves of banks at the Federal Reserve to determine when to halt the balance sheet contraction. Now that the U.S. Congress has raised the debt ceiling, Wall Street is focusing on the growing cash balance of the U.S. Treasury, as the Treasury is withdrawing excess liquidity from the system, which may make the market susceptible to unexpected events like the banking crisis two years ago.
In a report to clients on July 11, JPMorgan Chase's strategist team wrote, "Given the regional banking crisis that occurred in March 2023 (which highlighted the peak situation of massive deposit outflows) and the current regulatory framework (which places a high emphasis on liquidity), this threshold may need to be raised."
The latest market expectations survey conducted by the New York Fed in June indicated that the median level of reserves when the quantitative tightening policy ends is $2.875 trillion.
Since June 2022, the Federal Reserve has been gradually reducing its holdings of debt assets. In April, policymakers slowed the pace of reduction, lowering the monthly cap on U.S. Treasury securities that are not reinvested upon maturity from $25 billion to $5 billion. The cap on mortgage-backed securities remains unchanged at $35 billion.
Ultimately, policymakers are striving to avoid a repeat of the repo market turmoil seen in September 2019. At that time, as the Federal Reserve was shrinking its balance sheet, reserves had accumulated to unprecedented levels, leading to a cash shortage that triggered a sharp rise in key lending rates and the federal funds rate, forcing the central bank to take action to stabilize the funding market.
Waller stated in a speech at the Dallas Fed last week that in September 2019, the ratio of bank reserves to GDP had fallen below 7%, while around January 2019, when the ratio was about 8%, banks in the financial system "did not experience significant stress." With a buffer in place, Waller now believes that a shortage will occur when reserves fall below 9% of GDP
