The Federal Reserve may end this round of balance sheet reduction by the end of this year, but the possibility of a sudden brake is low

The end of the Fed's balance sheet reduction is in sight, but the actual conclusion depends on the speed of rate cuts and the pressure in the money markets.

Many on Wall Street believe that the sudden end of Quantitative Tightening (QT) is unlikely, with policymakers indicating that their reduction of U.S. Treasuries will be completed by the end of the year. However, recent data suggests that risks of economic slowdown and liquidity pressure have emerged in the financial system, casting doubt on the outlook.

Mark Cabana and Katie Craig, strategists at Bank of America, wrote in a memo to clients on Wednesday: "If the Fed is cutting rates to stimulate the economy, then QT may stop. If the Fed is cutting rates for policy normalization, then QT may continue."

Signs of a faster slowdown in U.S. economic growth than expected a few weeks ago led to a massive rally in global bonds on Monday, with traders betting that the Fed and other central banks will be more aggressive in cutting rates.

The global repricing has been so severe that at one point, interest rate swaps implied a 60% chance of an emergency rate cut by the Fed in the next week—much earlier than its scheduled meeting in September. Current pricing suggests a cut of around 38 basis points in September.

Concerns have also been raised about liquidity issues in the financial system, with questions about how much pressure the Fed's massive $7.2 trillion asset portfolio can withstand from further reductions without causing cracks in the money markets similar to what was seen five years ago.

In the past, policymakers have discussed the possibility that QT may not need to stop when rate cuts begin, as rate cuts counteract QT, which is seen as tightening monetary policy. However, the sudden economic downturn threatens a smooth transition.

The Fed's reserve balances are currently at $3.37 trillion, the highest level in nearly two months and generally considered ample. But if the Fed reduces this amount too much, there is a risk of triggering overnight funding market volatility, similar to what was seen in September 2019. The Fed has been reducing its balance sheet since June 2022, slowing down recently to ease potential pressures on money market rates.

Signs of pressure in the money markets persist. With increasing issuance of U.S. government bonds and major dealers holding near-record amounts of Treasuries, overnight repo rates are rising.

Meanwhile, until Thursday, the Fed's overnight reverse repo (RRP) facility balance has declined on each trading day this month, dropping to as low as $287 billion, the lowest level in over three years. It rose to $303 billion on Thursday.

Even as funding pressures intensify, contingency measures to address potential pressures have been put in place, including sponsored repos that provide relatively easy sources of funding and the Fed's standing repo facility, which allows eligible institutions to borrow cash at the top of the Fed's policy target range against Treasury and agency securities Barclays Bank's Chief Strategist Joseph Abate said that the repurchase rate needs to rise further before people will start actively using this tool.

"Two possible factors that could prematurely end the Fed's QT plan: liquidity drying up in the money markets, or a recession in the U.S. economy," wrote Morgan Stanley's Seth Carpenter, Matthew Hornbach, and Martin Tobias. "We believe neither of these outcomes is very likely."