The Federal Reserve's Focused Policy: Not Just Interest Rate Cuts, but Also Balance Sheet Reduction

The Federal Reserve's balance sheet reduction plan may soon enter its final stage, as signs of liquidity tightening emerge in the market. The FOMC may discuss the end of the balance sheet reduction timetable in an upcoming meeting.

According to the Chase Trading Desk, Citigroup stated in its latest research report that as the U.S. Treasury rebuilds its cash account, consuming reverse repo balances, bank reserves have begun to decline from high levels, and pressure in the repo market has significantly increased.

Recent data shows that the Secured Overnight Financing Rate (SOFR) has been above the Interest on Reserve Balances (IORB) for most of this month, and yesterday it was 11 basis points higher, breaking through the upper limit of the federal funds rate. Although this development has not triggered an immediate policy response, it could become a catalyst for Federal Reserve officials to discuss balance sheet issues in this week's meeting.

Citigroup expects that if pressure in the repo market continues, the Federal Reserve is likely to end balance sheet reduction before the end of this year, although the specific timetable may not yet be determined. Market participants need to closely monitor repo market dynamics and communication signals from the Federal Reserve to grasp the timing of policy shifts.

Balance Sheet Reduction Process Nearing Conclusion, Clear Signals of Repo Market Pressure

The Federal Reserve's balance sheet continues to shrink, but the pace has clearly slowed. According to Citigroup's research report, the Fed's holdings of U.S. Treasury securities have decreased from about $5.8 trillion to $4.2 trillion, while mortgage-backed securities (MBS) have fallen from about $2.7 trillion to $2.1 trillion. Loans have remained stable at around $5 billion to $7 billion since the last batch of loans was repaid under the Bank Term Funding Program (BTFP) at the end of last year.

On the liabilities side of the balance sheet, the most significant change is that liquidity has shifted from reverse repos and bank reserves to the U.S. Treasury's cash account. As of September 11, the Treasury's cash account has increased to about $680 billion and is expected to further rise to about $850 billion in the coming weeks according to Treasury guidance. Meanwhile, the reverse repo balance (RRP) has fallen to very low levels, around $17 billion, while bank reserves have decreased from about $3.4 trillion in early summer to $3.15 trillion.

As the reverse repo balance approaches zero, the additional liquidity flowing into the Treasury's cash account will mainly come from bank reserves. Citigroup expects bank reserves to decline to about $2.8 to $2.9 trillion by the end of the year. Although the overall minimum comfortable level of reserves may be below $2.8 trillion, indicating that repo market pressure is unlikely to experience nonlinear changes like those in 2018-2019, the market has already begun to show signs of pressure.

Citigroup's research points out that SOFR has remained at or above the IORB level throughout September, and yesterday it was 11 basis points higher than the IORB, breaking through the upper limit of the federal funds rate. As repo rates rise, banks and primary dealers obtained $1.5 billion in funding from the standing repo facility on Monday. Although the amount is currently small, usage may further increase in December

It is worth noting that despite the rising pressure in the repurchase market, the effective federal funds rate remains relatively stable. Citigroup's basic forecast suggests that the effective federal funds rate will remain stable, but there may be a slight risk of an increase in the coming months relative to the reverse repurchase rate.

The Federal Reserve May End Balance Sheet Reduction by Year-End

In light of the pressure signals emerging in the repurchase market, Citigroup expects Federal Reserve officials to discuss balance sheet issues at this week's meeting, but may not immediately announce a specific timetable. Citigroup continues to believe that the Federal Reserve may see enough market pressure by the end of the year to end balance sheet reduction.

The report's authors stated that they will continue to monitor developments in the repurchase market and the Federal Reserve's communication signals. Unlike the situation in 2018-2019, the current market pressure is growing relatively moderately, and the Federal Reserve is better prepared to address market liquidity issues, which means that any policy shift may be smoother.

For investors, changes in the pace of the Federal Reserve's balance sheet reduction may affect the short-term interest rate market and the bond yield curve. As the Federal Reserve may end balance sheet reduction, market liquidity is expected to stabilize, which could support risk assets while putting downward pressure on short-term interest rates