When Federal Reserve officials meet this week to decide whether to cut interest rates again, they’ll face another question that’s becoming increasingly urgent — how soon they should stop shrinking the bank’s $6.6tn portfolio of securities.
Money markets have been flashing warnings for several weeks that the process, known as quantitative tightening, may have run its course. Now, Wall Street strategists say, stress signals have gathered such momentum that the Fed may be forced to end QT as soon as this month.
Since the central bank started reducing its portfolio in June 2022, more than $2tn in funds have left the financial system. This has nearly emptied its main liquidity barometer — the reverse repurchase facility — just as a deluge of short-term debt issuance is luring more cash away.
In turn, a variety of interest rates used among banks to borrow and lend to each other have risen, while a tool introduced to dampen market pressures has seen regular use over the past week. Even the Fed’s benchmark rate, which is seen as less sensitive to liquidity conditions, has ticked higher within its range for the first time in two years.
Against this backdrop, Chair Jerome Powell is almost certain to address the fate of the Fed’s portfolio of securities at the October 28-29 meeting. A portion of a speech he delivered just two weeks ago was dedicated to the topic, signalling for the first time that the process could end in coming months.
For many on Wall Street, the Fed will need to move fast if it wants to avoid the kind of distortions that rocked money markets in September 2019. Back then, short-term rates skyrocketed as the central bank was tightening its portfolio again, putting at risk its ability to control costs and steer the broader economy.
“You can make the case that there’s not just a risk that the Fed is at the in-between stage, but they’re there,” said Mark Cabana, head of US interest rate strategy at Bank of America Corp. “There’s a very small echo of 2019 and that the Fed over-drained cash and likely knows it.”
Bank of America, along with JPMorgan Chase & Co, this week joined TD Securities and Wrightson ICAP among banks that expect the Fed to end QT at the October meeting. On Friday, Deutsche Bank became the latest bank to change its view, now also expecting an announcement next week. Several other banks have moved up the timing to December from early next year.
For Jason Granet, chief investment officer at BNY, what’s changed since Powell’s speech is that “the balance sheet has been elevated in the conversation.” The risk of waiting longer is that things get worse by year end.
“They see things and they’re ready to act,” Granet said in an interview. “I think that’s an environment that they’re going to be modestly more conservative than not.”
Policymakers slowed the runoff in April to get ahead of potential disruptions once the government raised the debt ceiling over the summer. Since July, Treasury has issued a slew of bills to rebuild its cash pile, draining bank reserves at the central bank which are put into government securities.
The Fed has long said that it would stop shrinking its portfolio once reserves fall near a level known as “ample”, the minimum needed to prevent market disruptions. Governor Christopher Waller previously estimated ample at around $2.7tn but has since indicated reserves may be already low enough. Reserves fell below $3tn earlier this month and stood at $2.9tn as of October 22.
“Money markets at current or higher levels should signal to the Fed that reserves are no longer ‘abundant,”’ Bank of America’s Cabana and Katie Craig wrote on Thursday. “By some metrics the Fed many also judge that reserves are no longer ‘ample.”’
Ending the balance sheet runoff early would allow the Fed to start buying securities again to beef up reserves. JPMorgan strategists expect the central bank will start temporary open market operations immediately after QT stops to alleviate funding stresses around settlement dates, and conduct more regular purchases of Treasury bills for reserve management purposes in early 2026.
Short-term rates have remained stubbornly elevated even outside key settlement periods for Treasury auctions and tax payments that are typically volatile. In the past month, the effective fed funds rate, which rarely moves between Fed rate-setting decisions, has risen three times within the target range.
By comparison, in 2018 it took several months for the benchmark to move that quickly, according to Matthew Raskin, head of US interest rate strategy at Deutsche Bank.
Cabana said depending on where the Fed believes short-term rates should be setting relative to interest on reserve balances, or IORB, it may have to “backfill” about $150bn.
Dallas Fed President Lorie Logan said in August that they were looking at market rates stabilising close to, or slightly below IORB. While views at the Fed on the ideal level of reserves have differed, patience may be running out after some rates moved above IORB.
The September 2019 turmoil revealed that the Fed has less tolerance for volatility in the fed funds rate and the “constellation of money market funds,” the JPMorgan strategists, led by Teresa Ho, wrote.
“Committing the same mistake twice could have significant ramifications,” they said.
Money markets have been flashing warnings for several weeks that the process, known as quantitative tightening, may have run its course. Now, Wall Street strategists say, stress signals have gathered such momentum that the Fed may be forced to end QT as soon as this month.
Since the central bank started reducing its portfolio in June 2022, more than $2tn in funds have left the financial system. This has nearly emptied its main liquidity barometer — the reverse repurchase facility — just as a deluge of short-term debt issuance is luring more cash away.
In turn, a variety of interest rates used among banks to borrow and lend to each other have risen, while a tool introduced to dampen market pressures has seen regular use over the past week. Even the Fed’s benchmark rate, which is seen as less sensitive to liquidity conditions, has ticked higher within its range for the first time in two years.
Against this backdrop, Chair Jerome Powell is almost certain to address the fate of the Fed’s portfolio of securities at the October 28-29 meeting. A portion of a speech he delivered just two weeks ago was dedicated to the topic, signalling for the first time that the process could end in coming months.
For many on Wall Street, the Fed will need to move fast if it wants to avoid the kind of distortions that rocked money markets in September 2019. Back then, short-term rates skyrocketed as the central bank was tightening its portfolio again, putting at risk its ability to control costs and steer the broader economy.
“You can make the case that there’s not just a risk that the Fed is at the in-between stage, but they’re there,” said Mark Cabana, head of US interest rate strategy at Bank of America Corp. “There’s a very small echo of 2019 and that the Fed over-drained cash and likely knows it.”
Bank of America, along with JPMorgan Chase & Co, this week joined TD Securities and Wrightson ICAP among banks that expect the Fed to end QT at the October meeting. On Friday, Deutsche Bank became the latest bank to change its view, now also expecting an announcement next week. Several other banks have moved up the timing to December from early next year.
For Jason Granet, chief investment officer at BNY, what’s changed since Powell’s speech is that “the balance sheet has been elevated in the conversation.” The risk of waiting longer is that things get worse by year end.
“They see things and they’re ready to act,” Granet said in an interview. “I think that’s an environment that they’re going to be modestly more conservative than not.”
Policymakers slowed the runoff in April to get ahead of potential disruptions once the government raised the debt ceiling over the summer. Since July, Treasury has issued a slew of bills to rebuild its cash pile, draining bank reserves at the central bank which are put into government securities.
The Fed has long said that it would stop shrinking its portfolio once reserves fall near a level known as “ample”, the minimum needed to prevent market disruptions. Governor Christopher Waller previously estimated ample at around $2.7tn but has since indicated reserves may be already low enough. Reserves fell below $3tn earlier this month and stood at $2.9tn as of October 22.
“Money markets at current or higher levels should signal to the Fed that reserves are no longer ‘abundant,”’ Bank of America’s Cabana and Katie Craig wrote on Thursday. “By some metrics the Fed many also judge that reserves are no longer ‘ample.”’
Ending the balance sheet runoff early would allow the Fed to start buying securities again to beef up reserves. JPMorgan strategists expect the central bank will start temporary open market operations immediately after QT stops to alleviate funding stresses around settlement dates, and conduct more regular purchases of Treasury bills for reserve management purposes in early 2026.
Short-term rates have remained stubbornly elevated even outside key settlement periods for Treasury auctions and tax payments that are typically volatile. In the past month, the effective fed funds rate, which rarely moves between Fed rate-setting decisions, has risen three times within the target range.
By comparison, in 2018 it took several months for the benchmark to move that quickly, according to Matthew Raskin, head of US interest rate strategy at Deutsche Bank.
Cabana said depending on where the Fed believes short-term rates should be setting relative to interest on reserve balances, or IORB, it may have to “backfill” about $150bn.
Dallas Fed President Lorie Logan said in August that they were looking at market rates stabilising close to, or slightly below IORB. While views at the Fed on the ideal level of reserves have differed, patience may be running out after some rates moved above IORB.
The September 2019 turmoil revealed that the Fed has less tolerance for volatility in the fed funds rate and the “constellation of money market funds,” the JPMorgan strategists, led by Teresa Ho, wrote.
“Committing the same mistake twice could have significant ramifications,” they said.