The Federal Reserve's balance sheet falls below $7 trillion! When will QT come to an end?
The Federal Reserve's balance sheet has fallen below $7 trillion for the first time, marking a reduction of approximately $2 trillion. The Federal Reserve maintains its plan to reduce $25 billion in U.S. Treasuries and $35 billion in MBS each month. Although the market generally expects QT to end by the end of 2024, recent surveys indicate that expectations for the end of QT have been delayed. Analysts believe that the Federal Reserve may announce the end of QT at the November meeting and stop in December
Since the COVID-19 pandemic in 2020, the Federal Reserve has been particularly cautious to avoid surprising Wall Street with its views on interest rates, the economy, or inflation, and has even faced criticism for "talking too much."
However, when it comes to its massive balance sheet and the liquidity it deems necessary to maintain market stability, the Federal Reserve may be criticized for being tight-lipped.
The total size of the Federal Reserve's balance sheet has fallen below $7 trillion for the first time since August 2020, indicating that the Fed has reduced its balance sheet by about $2 trillion in this round of tapering. The Federal Reserve stated in its latest announcement on Thursday that it will maintain the tapering pace, reducing $25 billion in U.S. Treasuries and $35 billion in MBS each month.
Brij Khurana, Senior Managing Director at Wellington Management Company, pointed out that earlier this year, there was a general belief that the Federal Reserve would end its quantitative tightening (QT) policy by the end of 2024, which is the process of reducing its balance sheet by allowing its owned assets to mature.
However, according to a survey of primary dealers by the Federal Reserve, expectations for ending QT have been pushed back in recent months. Moreover, a few weeks ago, Dallas Fed President Lorie Logan—known as the chief architect of the central bank's balance sheet—stated in a speech that "liquidity seems ample."
Her remarks surprised Khurana, especially given the reduction in reserves in the banking system and the increased use of the Fed's overnight reverse repurchase agreement tool (a closely watched liquidity indicator) around the end of the month. The benchmark borrowing rate is also rising, which is a sign of potential stress bubbling up in the financial market pipeline.
Khurana said, "They seem satisfied with this now."
How far is the Federal Reserve from ending QT?
Barclays interest rate strategist Joseph Abate stated in September that the Federal Reserve should announce the end of QT at its November meeting and stop QT in December.
Bank of America global interest rate strategists believe that when the Fed's first rate cut in four years arrives, QT will end. However, with the Fed conducting significant rate cuts in September, it is still allowing a certain amount of U.S. Treasuries and agency mortgage-backed securities to leave its balance sheet each month.
The Federal Reserve significantly expanded its asset holdings after the global financial crisis of 2007-08 and during the COVID-19 pandemic, causing its balance sheet to swell to nearly $9 trillion two years ago. At that time, the Fed's goal was to mitigate the severity of the U.S. economic recession by boosting risk appetite and capital markets, as well as controlling long-term interest rates.
The trickier part is how to return the balance sheet to a more normal level after the tumultuous past. During the period from the global financial crisis to before the pandemic, the Fed only slightly reduced its asset holdings To maintain order, the Federal Reserve has been reducing its balance sheet for the past two years. At the peak of the reduction, the Federal Reserve allowed up to $95 billion in U.S. Treasury and agency mortgage securities to mature each month without reinvestment. In June of this year, it slowed the pace of reduction, allowing up to $25 billion in Treasury securities to mature each month, down from the previous $60 billion, while keeping the agency mortgage securities reduction cap unchanged at $35 billion.
Federal Reserve officials have stated that they hope any quantitative tightening (QT) will be "like watching paint dry," meaning that this activity will occur quietly in the background without causing disruption. The overall goal of the Federal Reserve is to reduce liquidity in the banking system to a "sufficient" level without falling into the realm of "scarcity."
Logan stated in October that the reserve balance was $3.2 trillion, compared to $1.7 trillion at the beginning of 2020. Kurland noted that Wall Street estimates the minimum bank reserves needed may be close to $3 trillion.
It remains unclear where the threshold for the Federal Reserve to stop QT might be and whether it risks withdrawing too much liquidity from the market in the process. The Federal Reserve described the "sufficient" level of bank reserves in May as "uncertain," but indicated it would handle "unknown" situations cautiously.
Lou Crandall, chief economist at Wrightson ICAP, said in a phone interview, "They are far from ending QT." Instead, he indicated that the Federal Reserve's goal is to "gradually reach the target" while hoping to avoid market turmoil during the balance sheet reduction process.
Impact of the Election
The message the Federal Reserve is conveying to the market is that its plan for achieving an economic soft landing primarily focuses on interest rates rather than the size of its balance sheet.
On Thursday local time, the Federal Reserve continued to lower interest rates by 25 basis points, bringing its policy rate down to a range of 4.5% to 4.75%. However, former President Trump's victory in the election could have significant implications for its interest rate outlook.
Trump has promised that if elected, he would implement more tariffs and tax cuts, which could reignite inflation, limit the Federal Reserve's future rate cuts, and further increase the U.S. deficit.
Andrzej Skiba, head of U.S. fixed income at Royal Bank of Canada Global Asset Management, stated, "The worst-case scenario is rising inflation coupled with a slowing economy, which is not a combination the Federal Reserve wants to see."
In this scenario, Skiba expects the Federal Reserve to maintain interest rates in a restrictive zone and halt the balance sheet reduction. If the election results in additional tax cuts and deregulation, he anticipates this will be favorable for the stock market but unfavorable for bonds.
Crandall noted that the areas the Federal Reserve monitors to help gauge the "sufficient" reserve level currently show no warning signals, but the moment to end QT may come when the next Congress must reach an agreement on the U.S. debt ceiling. As MarketWatch editor Greg Robb recently pointed out, the current debt ceiling suspension will expire on January 1 of next year. If no agreement is reached, the Treasury will need to begin depleting its general account again to meet its obligations until an agreement can be reached.
Wrightson said, "You have to safely navigate through the debt ceiling impasse before this becomes a meaningful discussion."