Investors are eagerly awaiting the Federal Reserve’s announcement on Wednesday regarding the possibility of lower interest rates. However, there is another significant concern on Wall Street surrounding the central bank’s plans for its massive $7.7 trillion balance sheet and the potential risks associated with its rapid reduction.
To address the potential issues that could arise from shrinking the balance sheet too quickly, John Canavan, a lead analyst at Oxford Economics, predicts that the Fed will slow down the pace of reduction in the second quarter. He further expects the unwinding process to conclude in the second half of 2024.
Currently, the Fed allows $60 billion of Treasury securities and up to $35 billion in agency mortgage-backed securities to roll off its balance sheet each month. As a result, the balance sheet has already shrunk by $1.3 trillion from its record size of nearly $9 trillion during the pandemic.
In early January, Dallas Fed President Lorie Logan drew attention when she suggested that the Fed should slow down the ongoing reduction when overnight reverse repo balances reach a low level. This statement left market participants wondering when exactly this “low level” would be achieved and emphasized the importance of maintaining “ample” reserves to ensure smooth market functioning. Fed officials are keen to avoid a repeat of the September 2019 repo crisis, during which overnight lending rates spiked to as high as 10% according to some estimates.
A More Orderly Transition: Fed Officials Discuss the Future of Reserves
Mark Cabana and BofA Global’s rates research team have raised concerns about the potential challenges that lie ahead in transitioning from an abundant to ample reserve regime. As the Federal Reserve’s balance sheet continues to shrink and drain excess liquidity from the markets, attention must now be turned to managing this transition effectively.
One key indicator of excess liquidity, the Fed’s overnight reverse repurchase program, is projected to approach a zero balance within three months. This should serve as a prompt for the Fed to take swift action to prevent any potential issues from arising.
According to Cabana, once the reverse repurchase program’s balances are drained, there will be a need for new sources of cash to cover Treasury issuance, which is expected to increase coupon auction sizes. As a result, bank reserves are likely to decline as banks and other investors use their cash holdings to purchase the debt.
Despite these concerns, the stock market experienced a rally on Monday, reaching record highs. The Dow Jones Industrial Average (DJIA) and the S&P 500 index (SPX) both achieved their sixth record-close of the year. This surge followed the Treasury Department’s announcement that it plans to borrow $760 billion in the first quarter, $55 billion lower than previously estimated.
In reaction to this news, the yield on the benchmark 10-year Treasury note (BX:TMUBMUSD10Y) fell by 7 basis points to 4.089%. This marked the largest daily yield decline in approximately a month.
Related: The Fed’s Approach to Rate Cuts: A Portfolio Manager’s Perspective
