NY Fed survey shows big banks still expect spring halt to balance sheet shrinking Reuters

By Michael S. Derby

(Reuters) – Wall Street’s biggest banks expect the Federal Reserve to end the process of shrinking its balance sheet next April, keeping in line with what they told the central bank in July.

Banks also expect the Fed’s balance sheet to reach $6.4 trillion, well above the $4.2 trillion mark seen before the coronavirus pandemic hit in early 2020, according to a survey by the so-called primary dealers by the New York Fed ahead of the central bank’s Federal Open Market Committee meeting last month. These banks serve as counterparties to the Fed’s policy operations.

“Most dealers indicated that they expect the balance sheet reduction to be driven by assessments of reserve levels, overnight reverse takeovers or upward pressure on money market rates relative to administered rates,” the survey said. “Some dealers have suggested that macro factors are a risk to their outlook for the end of the run,” it added.

The release of Thursday’s survey comes a day after the US central bank released the minutes of the September 17-18 FOMC meeting. In that document, officials offered little new guidance on the balance sheet outlook, other than to note the importance of communicating that the ongoing drawdown may continue even as officials cut the Fed’s interest rate target.

The Fed’s latest balance sheet news comes as market participants are still coming to terms with an unexpectedly turbulent end to the third quarter. The last trading day of September saw high short-term rate volatility and the first real-world use of the SRF, a Fed liquidity tool, although conditions quickly returned to where they were before.

For just over two years, the Fed has been reducing its holdings of Treasuries and mortgage bonds as part of a process called quantitative tightening, or QT. This took the Fed’s overall holdings from a peak of $9 trillion in the summer of 2022 to the current level of $7.1 trillion.

For much of the tapering, QT effectively tightened monetary policy in tandem with the Fed’s rate hikes as policymakers tried to control high levels of inflation. But with pressures on prices easing considerably, the Fed cut its target overnight rate by half a percentage point last month, and for some in the markets, that has called into question the need for further cuts of the balance sheet.

Monitoring the money markets

However, Fed officials have repeatedly said that what happens to the balance sheet is separate from interest rate policy, the main lever of monetary policy. Central bankers have also reiterated that the drawdown will continue until excessive liquidity is removed from the financial system, even if they are not sure when that moment will arrive.

“Reserves are still plentiful and are expected to remain so for some time,” Fed Chairman Jerome Powell said after the September meeting. “What that tells you is we’re not thinking about stemming the flow,” even as interest rates fall.

These expectations are tested by money market conditions. On September 30, short-term rates were unexpectedly volatile and, for the first time, market participants surrendered a significant amount of eligible bonds to the Fed in exchange for cash at the SRF.

While on the surface it might appear to echo the events of September 2019, when the Fed ended its QT process due to interest rate volatility, in the current case the Fed has never lost control of its target federal funds rate as it did then.

The daily effective fed funds rate last week never fell below 4.83% – well within the current policy target range of 4.75%-5.00% – while in 2019 it traded above the target range set at that times. Overnight repo rates in the open market for general collateral rose 9 basis points for the day last week, the most in about 11 months, but have since settled back to where they were.

Most analysts see the latest turbulence as different from five years ago.

“Last week the rise in interest rates was purely a function of dealer balance sheet constraints rather than wider liquidity issues in the banking sector,” said analysts at Wrightson ICAP ( LON: ), adding that “soils reserves have remained in the range of the last two years”.

Some market participants argue that tighter conditions in the repo market, where participants borrow and lend bonds, could prompt the Fed to end QT relatively soon.

Minutes of the meeting showed that Fed officials and staff watching the markets for signs of liquidity shortages are keeping an eye on activity in the repo market.

Noting that market indicators pointed to still “ample” levels of reserves, the minutes signaled higher repo market rates on the back of large-scale sales of Treasury debt. The Fed’s official in charge of implementing monetary policy emphasized the connections between the repo market and the federal funds rate, which showed “the importance of monitoring a range of indicators to assess reserve conditions and the state of money markets,” the minutes said.