Liquidity alarm sounded! U.S. bank reserves fall below $3 trillion again, and the Federal Reserve's QT may come to an end in the coming months

According to the Zhitong Finance APP, the reserves of the U.S. banking system (a key consideration for the Federal Reserve's decision to continue reducing its balance sheet) have once again fallen below $3 trillion. Meanwhile, Federal Reserve Chairman Jerome Powell has signaled that quantitative tightening (QT) may come to a halt in the coming months.

According to data released by the Federal Reserve on Thursday, bank reserves decreased by approximately $45.7 billion in the week ending October 15, dropping to $2.99 trillion. This decline nearly offsets the previous week's increase of $54.3 billion.

The backdrop for this decline in reserves is that, following the increase in the debt ceiling in July, the U.S. Treasury has ramped up its bond issuance to rebuild cash balances. This operation drains liquidity from other liability items in the Federal Reserve's accounts, such as the Federal Reserve's overnight reverse repurchase agreement (RRP) tool and bank reserves.

However, as the RRP balance nears depletion, the reserves held by commercial banks at the Federal Reserve continue to decline. The drop in cash assets held by foreign banks even exceeds that of domestic U.S. banks.

As the Federal Reserve continues to push forward with balance sheet reduction (i.e., quantitative tightening/QT), these capital flows will affect the daily operations of the financial system. Due to the potential for QT to exacerbate liquidity strains and trigger market turmoil, the Federal Reserve has slowed the pace of balance sheet reduction earlier this year, reducing the amount of bonds allowed to roll off each month.

On Tuesday, Powell stated that balance sheet reduction would stop when bank reserve levels are slightly above the "adequate" level determined by policymakers (i.e., the minimum reserve size needed to prevent market turmoil). He explicitly pointed out that the Federal Reserve may approach this level in the "coming months," marking the strongest signal so far that the Federal Reserve believes this target is nearing.

Federal Reserve Governor Christopher Waller stated on Thursday at an event that the current size of the balance sheet has returned to a reasonable level corresponding to "adequate reserves." In July of this year, Waller estimated that the minimum adequate level of reserves is around $2.7 trillion.

"We maintain an adequate level of reserves to ensure that the banking system and financial markets have sufficient liquidity, ultimately avoiding situations where institutions scramble for small amounts of funding to make up for reserve positions," Waller said. "In my view, that kind of funding shortage is absurd."

Affected by changes in liquidity, the effective federal funds rate, which is a target of the Federal Reserve's policy, slightly increased within the target range last week—this marks the second increase in over two weeks, indicating that the financial environment may tighten further in the future. The rate currently remains within the 4% to 4.25% range set after the Federal Open Market Committee (FOMC) cut rates last month. Over the past two years, this rate has hovered near the lower limit of the range. Deutsche Bank noted that the 75th percentile of this rate rose from 4.10% to 4.12% this week, suggesting that the median rate may further increase.

The federal funds market was once an important channel for overnight interbank lending and was often used as a signal to gauge whether financing conditions were tightening. However, during the financial crisis and the pandemic, large-scale monetary stimulus policies flooded the U.S. banking system with dollars, leading banks to significantly withdraw from the federal funds market and instead deposit funds directly with the Federal Reserve Currently, the trading volume behind the federal funds rate has decreased. On one hand, the excess funds that non-U.S. institutions can allocate in the market have reduced; on the other hand, as the largest lending group in this market, the Federal Home Loan Banks are shifting more funds to the repurchase market due to higher rates in that market