Liquidity "Stress Test": When will the Federal Reserve end its balance sheet reduction?

From June 2022 to the end of 2024, the Federal Reserve has cumulatively reduced its balance sheet by nearly $2 trillion. What is the liquidity situation in the U.S. money market? With the onset of the interest rate cut cycle, how far is the endpoint of balance sheet reduction? Will the "repo crisis" of September 2019 or the "treasury tantrum" of October 2023 be repeated?

I. Liquidity "Stress Test": Reverse repos drop to hundreds of billions, what are the "variables" in the Fed's balance sheet reduction?

The "normalization" of the Federal Reserve's unconventional monetary policy follows a certain order, but it cannot be mechanically inferred from historical experience that the endpoint of balance sheet reduction is just around the corner with the onset of the interest rate cut cycle. This is because the normalization of interest rates and the normalization of the balance sheet are two separate decision-making frameworks. Therefore, one cannot conclude that the endpoint of balance sheet reduction is near simply because the Federal Reserve begins to cut interest rates in September 2024.

Since June 2022, the Federal Reserve has reduced its balance sheet by $2 trillion, but reserves have "remained almost unchanged." This is mainly because reverse repos have "supplemented" the liquidity absorbed by balance sheet reduction and fiscal financing. However, the function of reverse repos as a "water tank" is about to reach its limit. The federal funds market will face a "stress test," and the Fed's balance sheet reduction plan will have to make timely decisions.

Generally speaking, in the "second half" of balance sheet reduction, as liquidity becomes tighter, the Federal Reserve will "technically" lower the policy interest rate to prevent money market rates from exceeding the upper limit of the FFR target range. In the December 2024 meeting, the Federal Reserve "technically" lowered the overnight reverse repo rate by 30 basis points to 425 basis points, which will alleviate the pressure of rates "breaking through" the upper limit of the FFR range.

II. The process of balance sheet reduction: After reducing the balance sheet by $2 trillion, is liquidity in the U.S. money market still "excessive"?

The guiding principle of the Federal Reserve's balance sheet reduction is to transition the supply of reserves from an "excess" state to a "sufficient" state, ending the reduction before reaching a "shortage." The state of reserve supply can be observed from the perspectives of quantity, interest rate spreads, or elasticity. In principle, as the supply of reserves moves from excess to shortage, the demand curve for reserves will shift from flat to steep, the volatility of interest rate spreads will increase, and elasticity will shift from zero to negative.

Based on the experience of balance sheet reduction from 2017 to 2019: When the ratio of reserves to GDP is greater than 10%, reserves are relatively "excessive"; when the ratio falls below 10%, reserves enter the "sufficient" range; when the ratio falls below 8%, reserves begin to show signs of shortage; and when the ratio falls to 6%, the money market experiences a "repo crisis"—a severe "shortage" of reserve supply.

Overall, liquidity in the U.S. money market remains in an "excess" state, but certain areas may already be in a "sufficient" state. As of the end of 2024, the ratio of reserves to GDP has decreased to 10.9%, down 2 percentage points from June 2022. Roughly speaking, it is expected that by mid-2025, the supply of reserves may enter the "sufficient" range, and by early 2026, it will begin to enter a "shortage." In the range, the third quarter of 2026 will enter the "extreme shortage" range (reserves/GDP=6%).

III. The endpoint of balance sheet reduction: the "repo crisis" in September 2019 or the "treasury tantrum" in October 2023?

2025 is the year when the broad liquidity of the U.S. money market transitions from "excess" to "adequate," and it may be the year the Federal Reserve ends balance sheet reduction. Assuming that there are no further adjustments to the balance sheet reduction plan in 2025, by the end of 2025, the Federal Reserve will have reduced its balance sheet by a total of $540 billion, bringing total assets down to $6.3 trillion, and reserves down to $2.4 trillion (with other liabilities unchanged), resulting in a reserves/GDP ratio of approximately 8%.

Will the "repo crisis" of 2019 be repeated? The probability of a repeat is low: (1) With the experience and lessons from the last time, the Federal Reserve may slow down and stop balance sheet reduction when reserve supply is slightly above the "adequate" level; (2) The Federal Reserve is improving the "interest rate corridor" system, such as establishing the Standing Repo Facility (SRF) in July 2021;

A potential disruptive factor is the new round of "debt ceiling" negotiations—which may lead to significant fluctuations in reserves, thereby disrupting the pace of the Federal Reserve's balance sheet reduction. During the "treasury tantrum" in the fall of 2023, the 10-year U.S. Treasury yield broke 5%, due to factors including the Federal Reserve's balance sheet reduction, increased Treasury issuance, and economic resilience and uncertainty in Federal Reserve policy. In 2025, these three factors will still be present, and if they overlap, they may still lead to an overshoot in U.S. Treasury yields.

Report Body

From June 2022 to the end of 2024, the Federal Reserve will have cumulatively reduced its balance sheet by nearly $2 trillion. What is the liquidity situation in the U.S. money market? With the onset of the interest rate cut cycle, how far is the endpoint of balance sheet reduction, and will the "repo crisis" of September 2019 or the "treasury tantrum" of October 2023 be repeated?

I. Liquidity "Stress Test": Reverse repos drop to hundreds of billions, what are the "variables" in the Federal Reserve's balance sheet reduction?

The "normalization" of the Federal Reserve's unconventional monetary policy has a certain order, but it cannot be mechanically inferred from historical experience that with the onset of the interest rate cut cycle, the endpoint of balance sheet reduction is just around the corner. This is because interest rate normalization and balance sheet normalization apply to two different decision-making frameworks. The experience of balance sheet reduction from 2017 to 2019 shows that after the Federal Reserve's first interest rate cut in July 2019, it ended balance sheet reduction in September and immediately began "expanding the balance sheet" (not QE, but through reverse repos). So, with the Federal Reserve starting to cut interest rates in September 2024, is the endpoint of balance sheet reduction approaching?

![](https://mmbiz-qpic.wscn.net/sz_mmbiz_png/KwakKa935bt7M9Zqk6c0hLicGhbEceIVCKhwOZz6SYibsoyicib5z03pIecqGTTHQayiavqKZibfZMBOg6WgpWYryubw/640? Since June 2022, the Federal Reserve has reduced its balance sheet by $2 trillion, but reserves have "remained almost unchanged." By the end of 2024, the Federal Reserve's total assets are expected to decrease from $8.9 trillion to $6.9 trillion (-$2 trillion). Among these, the holdings of Treasury bonds have decreased from $5.8 trillion to $4.3 trillion (-$1.5 trillion), and the holdings of MBS have decreased from $2.7 trillion to $2.2 trillion (-$0.5 trillion). However, on the liability side, reserves have only decreased from $3.3 trillion to $3.2 trillion, while reverse repos (deposits) have sharply declined from $2.3 trillion to $0.6 trillion (a reduction of $1.7 trillion) — the decrease is mainly in reverse repos from domestic institutions (which fell from $2 trillion to $0.2 trillion, with a minimum of only $0.13 trillion), primarily held by money market funds (MMF). To some extent, it is precisely because reverse repos have "supplemented" the liquidity absorbed by balance sheet reduction and fiscal financing that the federal funds market has remained stable until now.

However, the function of reverse repos as a "water tank" is about to "reach the end of the water." The reverse repo deposits from domestic institutions in the United States may further decline, and once they are exhausted, subsequent balance sheet reduction or fiscal financing will absorb reserves. The federal funds market will face a "stress test" in 2025, and the Federal Reserve's balance sheet reduction plan will also have to make timely decisions. ** At the December 2024 meeting, the Federal Reserve lowered the target range for the federal funds rate (FFR) by 25 basis points to 425-450 basis points while also "technically" lowering the overnight reverse repurchase (ON RRP) rate by 30 basis points to 425 basis points—aligning with the lower limit of the FFR target range, and the spread between the interest on reserves balances (IORB, 4.4%) and ON RRP (IORB-ON RRP) widened from 10 basis points to 15 basis points. This is because the volatility of the secured overnight financing rate (SOFR) has significantly increased, repeatedly breaking through the upper limit of the FFR. In the Implementation Note, the Federal Reserve stated that "setting the reverse repurchase rate at the lower limit of the FFR target range aims to support the effective implementation of monetary policy and the smooth operation of the short-term financing market." This technical adjustment compresses the arbitrage space of reverse repos, which may further reduce the scale of reverse repos and temporarily alleviate the "absorption" pressure on reserves from balance sheet reduction.

Generally speaking, in the "second half" of balance sheet reduction, as liquidity tightens, the Federal Reserve will "technically" lower policy rates (IORB or ON RRP) to prevent money market rates from breaking through the upper limit of the FFR target range. Specifically: (1) only lower IORB (the IORB-ON RRP spread narrows); (2) only lower ON RRP (the IORB-ON RRP spread widens); (3) simultaneously lower IORB and ON RRP, with potentially different adjustment magnitudes. In extreme cases, ON RRP can be below the lower limit of the FFR target range, as seen in the 2019 case. In July 2019, when the first rate cut of 25 basis points occurred, the FFR target range, IORB, and ON RRP were all lowered by 25 basis points (the ON RRP rate equaled the lower limit of the FFR target range). However, during the second rate cut in September, the Federal Reserve lowered the FFR target range by 25 basis points (to 1.75-2%), but both IORB and ON RRP rates were lowered by 30 basis points In October, the third rate cut operated similarly, with the FFR target range falling to 1.5-1.75%, and the IORB and ON RRP rates decreasing to 1.55% and 1.45% respectively—spreads remained unchanged, but ON RRP was 5 basis points lower than the lower limit of the FFR range. This was mainly due to the ongoing balance sheet reduction, which led to a continuous contraction of reserves, resulting in a "shortage" of liquidity in the money market, ultimately creating a "repo crisis" in mid-September 2019.

II. The Process of Balance Sheet Reduction: After a $2 Trillion Reduction, Is U.S. Money Market Liquidity Still "Excessive"?

The Federal Reserve's guiding principle for balance sheet reduction is to transition the supply of reserves from an "abundant" state to an "ample" state. Ideally, the end point of balance sheet reduction should fall before the "ample" level. How is "ample reserves" defined? Whether reserves are "ample" is relative to demand, dynamic rather than static, and more likely a range rather than a specific value. "An ample reserve supply can be described as a state where the federal funds market is not particularly sensitive to significant short-term changes in the supply and demand for reserves, but may have some moderate response." Powell stated in a speech in 2019: "Even in the face of fluctuations in reserve demand, the supply of reserves must meet that demand. In other words, an ample reserve supply equals reserve demand, plus a buffer that allows for fluctuations in the reserve market." However, "reserve demand" is unknown and time-varying, and the Federal Reserve can only "cross the river by feeling the stones."

In principle, the state of reserve supply can be observed from aspects such as quantity, interest rate spread, or elasticity (which are essentially consistent). As the reserve supply moves from (relatively) surplus to (relatively) shortage, the reserve demand curve will shift from "flat" to "steep," the volatility of interest rate spreads will increase, and elasticity will change from zero to negative. Based on the empirical rule from the balance sheet reduction between 2017 and 2019: when the ratio of reserves to GDP is greater than 10%, the reserve demand curve is essentially horizontal—indicating that reserve supply is relatively "surplus"; when the ratio of reserves to GDP falls below 10%, the reserve demand curve begins to "steepen" (interest rate spreads narrow)—indicating that reserve supply enters the "adequate" range; when the ratio of reserves to GDP falls below 8%, the EFFR-IORB spread converges to 0, and the volatility of the SOFR-IORB spread significantly increases, indicating that reserve supply begins to show signs of shortage. When the ratio of reserves to GDP falls to 6%, a "repo crisis" occurs in the money market—indicating that reserve supply is "extremely scarce."

As of the end of 2024, the ratio of reserves to GDP has fallen to 10.9%, a decrease of 2 percentage points compared to June 2022 (although reserves "have hardly changed," the nominal GDP in the denominator is growing rapidly). Assuming a reduction of 180 billion each quarter (the maximum rate, with the actual rate being about 120 billion per quarter), and assuming that the scale of accounts such as TGA remains unchanged, it is expected to fall below 10% in the second quarter of 2025 and drop to 8% by the end of the year. Therefore, roughly speaking, by mid-2025, reserve supply may enter the "adequate" range, and by early 2026, it will begin to enter the "shortage" range, with the "extremely scarce" range being reached in the third quarter of 2026 (reserves/GDP = 6%).

As of the end of 2024, the overall liquidity in the U.S. money market remains in a "surplus" state, but at specific points in time (quarter-end), it may already be in an "adequate" state. In 2025, it is necessary to closely monitor the volatility of money market interest rates or the elasticity of interest rate spreads. ** Although the spread between EFFR and IORB remains stable at -7bp, the Reserve Demand Elasticity calculated based on EFFR remains stable around 0, with no signs of turning negative. However, the volatility of the spread between SOFR and IORB has significantly increased, rising above 10bp at the end of Q3 and the end of 2024—breaking through the upper limit of the FFR target range. From the distribution, it can be seen that the 75th percentile of the SOFR rate has already exceeded the upper limit of 4.5%. Therefore, it can be said that although the liquidity in the federal funds market—where lenders are primarily represented by government-sponsored enterprises (GSE) such as the Federal Home Loan Banks (FHLB) and borrowers are mainly foreign banks—remains excessive, the liquidity in the short-term financing market, which is more participated in by other non-bank institutions or small and medium-sized banks, may have already entered the "sufficient" range in advance. Compared to the balance sheet reduction cycle from 2017 to 2019, the current liquidity situation may be comparable to the first half of 2018.

3. The Endpoint of Balance Sheet Reduction: The "Repo Crisis" of September 2019 or the "Treasury Panic" of October 2023?

2025 will be the year when the broad liquidity of the U.S. money market transitions from "excess" to "sufficient," and it will also be the year when the Federal Reserve ends its balance sheet reduction. Since the slowdown of balance sheet reduction in May 2024, the monthly cap for the Federal Reserve's balance sheet reduction has decreased from $95 billion to $60 billion ($25 billion in Treasury and $35 billion in MBS). The actual situation is that Treasury is being reduced at a rate of approximately $25 billion per month, while the reduction in MBS is about $15 billion per month (affected by natural maturities and early repayments), totaling $40 billion per month ($120 billion per quarter). Assuming that there are no further adjustments to the balance sheet reduction plan in 2025, by the end of 2025, the Federal Reserve will have reduced its balance sheet by a total of $480 billion, bringing total assets down to $6.4 trillion and reserves down to $2.7 trillion (assuming other liability items remain unchanged), with a reserve-to-GDP ratio of approximately 8.8% (0.7 percentage points higher than the previously assumed full-speed balance sheet reduction)

As the balance sheet reduction approaches its end, liquidity in the U.S. money market will further tighten. Will the "repo crisis" of 2019 repeat itself? We tend to believe that the probability of a repeat is low, just as the slowdown in balance sheet expansion at the end of 2021 also caused panic (Taper Tantrum).

How did the "repo crisis" of September 2019 occur? On one hand, the supply of reserves was already in a shortage zone. After the balance sheet reduction began in October 2017, reserves started to decline rapidly. By the end of August 2019, reserves had dropped to $1.5 trillion (further declining to $1.39 trillion on September 18), a decrease of $700 billion (32%) compared to September 2017 ($2.2 trillion) and a decrease of $1.3 trillion (46%) compared to October 2014 ($2.8 trillion). The ratio of reserves to GDP fell from a peak of 15% to below 7%, while the ratio to total assets of commercial banks dropped from a peak of 19% to 8%. On the other hand, the end-of-quarter corporate tax payments and the delivery of Treasury bond auctions significantly increased the demand for reserves, widening the supply-demand gap. September 16 was the deadline for corporate quarterly tax payments, and companies withdrew funds from bank deposits or money market fund (MMF) accounts to transfer to the Treasury's General Depository Account (TGA) at the Federal Reserve; on September 16, there was also $54 billion in Treasury bonds delivered, increasing the repo financing demand from primary dealers. Together, these two factors "occupied" about $120 billion in reserves.

The reasons why the probability of a repeat of the "repo crisis" is low include: (1) With the experience and lessons from the last time, the Federal Reserve may cautiously advance the balance sheet reduction in 2025: on one hand, it can slow down the reduction again before finally stopping (for example, by lowering the cap on the reduction of Treasury bonds); on the other hand, it can end the reduction before confirming that reserves have entered the "adequate" range. The balance sheet reduction plan from May 2022 indicated that "to ensure a smooth transition, the committee plans to slow down and stop the balance sheet reduction when reserves are slightly above adequate levels." "It should be noted that after the Federal Reserve stops the balance sheet reduction, reserves will also decrease due to the increase in other liability accounts. Therefore, the timing of the Federal Reserve's planned halt to the balance sheet reduction may fall within the 'excess' range, and then continue to 'absorb' reserves through other liability items, further lowering them to the 'adequate' range. SOMA manager Roberto Perli confirmed in a public speech in May 2024 that 'when the FOMC judges that the reserve balance is slightly above the level consistent with adequate reserves, it will signal the open market desk to stop the balance sheet reduction.' (2) The Federal Reserve has improved the 'interest rate corridor' system, such as establishing the Standing Repo Facility (SRF) in July 2021 'to serve as a backstop for the money market, supporting the effective implementation and transmission of monetary policy, as well as the smooth operation of the market.'

A potential disruptive factor is the new round of 'debt ceiling' negotiations—which may lead to significant fluctuations in reserves, thereby disrupting the pace of the Federal Reserve's balance sheet reduction. After the suspension of the debt ceiling on June 1, 2023, the issuance of U.S. Treasury bonds surged. This was the 'catalyst' for the 'Treasury tantrum' in the fall of 2023, causing the 10-year U.S. Treasury yield to break above 5%, marking the peak of the current rate hike cycle. Decomposition through the ACM model indicates that the rise in U.S. Treasury yields is mainly contributed by the term premium, which can be specifically attributed to the Federal Reserve's balance sheet reduction, increased Treasury issuance, as well as economic resilience and uncertainty in Federal Reserve policy. In 2025, these three factors will still exist, and if they overlap, they may still lead to an overshoot in U.S. Treasury yields.

Regarding the debt ceiling, if the Republicans and Democrats can successfully reach an agreement, the likelihood of a sharp increase in debt supply pressure is low. Conversely, if the debt ceiling comes into effect, the balance sheet reduction will 'absorb' reserves, but the TGA account will 'create' reserves, temporarily alleviating the supply pressure on reserves; however, after the debt ceiling is resolved, both the balance sheet reduction and the TGA account will 'absorb' reserves, leading to a rapid increase in reserve supply pressure In this case, the Federal Reserve may choose to end/suspend the balance sheet reduction before resolving the debt ceiling.

According to the New York Fed's primary dealer and market participant survey (sample size of 42), 39% of respondents believe that the timing for ending the balance sheet reduction may fall within the range of $6.25-6.5 trillion for the SOMA account balance. By the end of 2024, the securities balance held in the SOMA account is expected to have decreased to $6.5 trillion. This indicates that the timing for the Federal Reserve to end the balance sheet reduction is indeed approaching (around mid-2025).

In summary, the most pragmatic approach is always to "take one step at a time." In practice, in addition to the interest rates, interest spreads, or elasticity indicators mentioned earlier, one can also observe the distribution of the intraday Effective Federal Funds Rate (EFFR) or Secured Overnight Financing Rate (SOFR), the financing scale of domestic banks in the federal funds market, the timing of interbank payments, the scale of intraday overdrafts, and the share of repos at rates greater than or equal to the Interest on Reserve Balances (IORB). Overall, by the end of 2024, the increase in quarter-end interest rate volatility may indicate that the supply of reserves is already in the "excess" tail range, which may continue until around mid-2025. At that time, the Federal Reserve may decide when to further slow down the balance sheet reduction or directly stop it based on market conditions.

Author: Zhao Wei (A0230524070010), Chen Dafei, Source: Shenwan Hongyuan Macro, Original Title: "Liquidity 'Stress Test': When Will the Federal Reserve End Balance Sheet Reduction?"

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