Analysis-Fed’s balance sheet endgame may play out over a longer-than-expected horizon

© Reuters. FILE PHOTO: The Federal Reserve building in Washington, U.S., January 26, 2022. REUTERS/Joshua Roberts/File Photo

By Davide Barbuscia and Michael S. Derby

NEW YORK (Reuters) – Federal Reserve officials are keen to start debating their balance sheet run-down endgame, but benign market conditions, recent central banker comments and bond dealer estimates now suggest the process may run longer than previously thought.

One factor driving the rethink is a puzzling bout of better-than-expected liquidity conditions in U.S. short-term financing markets that has for now at least forestalled a run of volatility that some on Wall Street had expected to force the Fed’s hand into stopping the balance sheet shrinkage effort known as quantitative tightening.

On top of that, minutes of the Fed’s most recent meeting in January showed some policymakers interested in an extended slowdown in the pace of shrinkage – a tapering – that could actually allow QT to proceed for a longer period. And bond dealers also now project that QT will not end outright until next year rather than late this year and leave the Fed with an even smaller balance sheet.

How this plays out in the months ahead is a secondary – but still important – obsession on Wall Street to the guessing game over when the Fed starts rate cuts. That’s because the Fed’s only previous QT effort in 2018-19 ended in a market ruckus that no one wants to see repeated.

“At the moment, the key concept in both rate and balance sheet policy is discretion,” said Jonathan Cohn, head of U.S. rates desk strategy at Nomura Securities International. “Without evident pressure in funding markets, the Fed has discretion regarding when it slows QT.”

The Fed scooped up about $4.6 trillion of bonds during the COVID-19 pandemic as one of its planks alongside near-zero interest rates to prop up the economy through the health crisis. The effort to add liquidity to the financial system and keep it running smoothly more than doubled the size of its overall balance sheet to roughly $9 trillion.

When a surge in inflation forced the central bank to start jacking up interest rates in March 2022, officials soon after started winnowing down the size of its stash of Treasuries and mortgage-backed securities, allowing up to $95 billion a month to mature from the balance sheet without being replaced.

Total Fed bond holdings are now down to about $7.1 trillion and the full balance sheet has fallen to just below $7.7 trillion.

SOFT FUNDING

A combination of larger Treasury debt issuance, higher interest rates and Fed QT had been expected to continue to drain liquidity this year, potentially inducing volatility in short-term funding markets, but so far that’s not happened. In fact, the borrowing rate in a key repurchase agreement (repo) market, where banks and other market players swap cash for Treasuries, has declined in recent weeks.

“There’s been soft funding recently, overnight rates have been a little softer,” said Scott Skyrm, executive vice president of money market trading firm Curvature Securities.

Just why remains unclear.

“We don’t have a good answer for it, we’re asking ourselves the same question,” said Joe DiMartino, head of the repo desk at Clear Street. “There just seems to be way more cash than anticipated over the last several weeks.”

A key upshot is usage of the Fed’s overnight reverse repo facility (ONRRP), which had become a favored place for Wall Street firms to park excess cash and a touchstone for Fed officials for market liquidity levels, may hold up more than expected. Its daily usage shrank over the last year from more than $2 trillion to an average of about $540 billion through February.

As cash drains from ONRRP, still-abundant bank reserves at the Fed are expected to start falling, leading to a tightening in overall financial system liquidity that the Fed wants to keep under control by tapering QT.

“The reality is that the drive to lower balances within the reverse repo facility has a little bit of upward pressure on it, and it won’t necessarily get to zero anytime soon,” said Jerome Schneider, leader of short-term portfolio management and funding at bond giant PIMCO.

2025 NOW EYED FOR QT END

Last week’s minutes from their latest meeting showed an eagerness by many Fed officials to get moving on planning the QT endgame. That said, the minutes showed “some participants” eyeing a plan to start a prolonged taper process that would allow QT to continue at a diminishing pace even after rate cuts begin later this year.

On the heels of that, the release late last week of the survey of primary dealers conducted ahead of each Fed policy meeting showed firms also expect a lengthy tapering operation starting this summer. They have pushed out estimates for when QT ends entirely to January or February 2025 from the fourth quarter of 2024 as estimated in the survey ahead of December’s Fed meeting.

Moreover, the latest dealer survey pegs the Fed’s bond portfolio balance at $6.5 trillion at the end of QT – $250 billion less than estimated previously. And they also see more room for ONRRP levels to decline before QT ends – to $125 billion versus $375 billion in the December survey.

Still, most Fed officials recognize the uncertainty ahead of them and want to proceed carefully so as not to repeat the events of five years ago.

Philadelphia Fed President Patrick Harker last week said he favors proceeding “methodically” while watching for market tightness to flare up. Atlanta Fed President Raphael Bostic told CNBC earlier this month that “we just want to make sure our actions don’t cause disruptions.”

That said, some in the Fed are less worried about smooth moves. Jeffrey Schmid, new president of the Kansas City Fed, said Monday: “I don’t favor an overly cautious approach to balance sheet runoff for the sake of avoiding any volatility in interest rates. Instead, some interest-rate volatility should be tolerated as we continue to shrink our balance sheet.”