The debt ceiling deadlock is blocking the way, will the Federal Reserve soon stop tapering?

As the Federal Reserve continues to reduce its balance sheet, the issue of the U.S. debt ceiling has resurfaced, putting the Fed in a bind, and this time it is more complicated. The U.S. federal debt ceiling will be reinstated on January 2 next year, prompting the U.S. Treasury to take a series of extraordinary measures, including cutting cash reserves and reducing the issuance of Treasury bonds to maintain its borrowing capacity.

Since the cash balance of the U.S. Treasury—namely the Treasury General Account (TGA)—is one of the main liabilities on the Fed's balance sheet, such measures will primarily boost the reserves that banks hold at the Fed, as well as the demand for the overnight reverse repurchase agreement (RRP) tool. This means that as the Fed continues to shrink the size of its balance sheet during the quantitative tightening (QT) process, the market will have ample cash.

However, once Congress passes legislation to suspend or raise the debt ceiling, the U.S. Treasury will quickly rebuild its cash balance, a process that will siphon cash out of the financial system. The transfer of funds between the market and government cash accounts has the potential to obscure some signals that are crucial for identifying the pressures caused by the Fed's balance sheet restructuring.

Gennadiy Goldberg, head of U.S. interest rate strategy at TD Securities, stated, "As the debt ceiling begins to depress the TGA balance and temporarily increase reserves in the system, the Fed may be blind to the impacts of QT. This also raises the risk that once the debt ceiling is raised, reserves will quickly diminish, leading to a severe shortage."

The minutes from the Fed's November meeting indicate that staff briefed the committee on the potential impacts of reinstating the debt ceiling. All of this makes it more difficult for market participants and policymakers to determine when QT will end. The minutes show that in the primary dealer survey conducted by the New York Fed's open market desk and the market participant survey, two-thirds of respondents expect QT to end in the first or second quarter of 2025.

During the last debt ceiling incident in 2023, the Fed had been reducing its balance sheet for less than a year and still had $2.2 trillion in overnight reverse repurchase agreements—a tool seen as a barometer of excess liquidity. However, once Congress suspends the ceiling, the U.S. Treasury will rebuild its cash balance by increasing the issuance of Treasury bonds, leading money market funds to withdraw from the RRP. This time, by 2025, that figure is less than $150 billion.

This means that any rebuilding of the TGA will lead to a decline in bank reserves. Although the current size of this account is $3.23 trillion, which policymakers consider to be a sufficient level, market observers are closely monitoring this level to assess when it will become scarce In addition, Morgan Stanley stated that due to the different background of the financing market compared to last time, there is a greater risk of increased volatility. Morgan Stanley strategist Martin Tobias wrote in a report released a year in advance that since 2023, the long positions in U.S. Treasury bonds held by hedge funds have "increased significantly," with even more collateral outside the Federal Reserve and the banking system.

Considering that the U.S. Treasury will likely have to reduce bond issuance before raising or suspending the debt ceiling, money market funds will be incentivized to deposit more cash in the RRP, despite higher rates in the private repurchase market. Similar friction occurred in July when dealers' balance sheet constraints and collateralized repurchase restrictions made the use of reverse repurchase tools tricky.

Tobias wrote, "Capacity constraints, as well as counterparty risk limits, could push money market fund capital into the RRP, hindering the liquidity redistribution process. This effectively reduces the supply of repo financing as demand continues to grow."

Although most Wall Street strategists agree on when the Federal Reserve's balance sheet contraction should end—by the first quarter of 2025, determining when the U.S. government will run out of funds (the so-called X date) has become more difficult.

Before Trump won the election, strategists initially predicted the X date to be around August 2025. Now, some say this date is more likely to be moved up to sometime in the second quarter, as the Republicans have taken control of the White House and Congress.

Nevertheless, all this uncertainty will make it more challenging for the Federal Reserve to assess the short-term interest rate risks of QT. Royal Bank of Canada Capital Markets strategists expect the Federal Reserve to halt QT in the second half of 2025 and point out that policymakers' statements indicate that there is still a long way to go in the balance sheet reduction.

Led by Steven Zeng and Matthew Raskin, Deutsche Bank strategists suggest that policymakers may consider enhancing market monitoring to ensure liquidity support tools are ready, further slowing the pace of the second round of balance sheet reduction, and pausing the reduction until the debt ceiling issue is resolved, or ending the reduction early, although they believe the latter two options are unlikely.

Wells Fargo strategist Angelo Manolatos stated, "Expanding the balance sheet is easy. Reducing it is difficult."