Federal Reserve research firm Wrightson ICAP has stated that as the outlook for bank reserves becomes increasingly bleak, the Federal Reserve will need to begin to stop reducing its balance sheet.

In the past 18 months, the Federal Reserve has allowed up to $60 billion of treasury bond bonds and up to $35 billion of institutional bonds to automatically expire and not renew.

Lou Crandall, chief economist of Wrightson ICAP, said that taking a more cautious attitude may lead the Federal Reserve to slow down the pace of quantitative tightening (QT) after the meeting in June next year, and reduce the monthly ceiling of the reduction of US treasury bond bonds to $30 billion in the third quarter. However, it is expected that the divestiture of mortgage backed securities (MBS) will continue at the current speed for the time being.

Federal Reserve policymakers believe that the current $3.5 trillion in bank reserves are abundant. However, a series of factors, including the financing pressure at the end of the month and the presence of a large number of treasury bond on the dealer's balance sheet, to a certain extent pushed the guaranteed overnight financing rate (SOFR) to the highest level in history last week. These market turbulence highlight the sensitivity of the financing market to bank balance sheets and the Federal Reserve's QT plan.

The Federal Reserve is continuing to shrink its balance sheet

Crandall wrote in a report to clients on Monday, "In the formulaic asset liability landscape discussed by the Federal Reserve over the past few years, its normalized dynamics will erode bank reserves over time. However, currently, the Federal Reserve's balance sheet or front-end dynamics are almost abnormal."

Even before the sudden surge in SOFR last week, investors were closely monitoring the Federal Reserve's QT. This is because the movement of the Federal Reserve's own reserves is crucial to the liquidity level of the entire banking system, which in turn determines the crucial money market that businesses and banks rely on for financing on a daily basis.

Since June last year, as the Federal Reserve continues to tighten monetary policy, the Federal Reserve's Overnight Reverse Repurchase Facility (RRP), a tool used by money market funds to earn interest from excess cash, has seen outflows of over $1.2 trillion. The current RRP balance is $839 billion, and it is concerning that once the tool is depleted, the Federal Reserve will have to stop QT.

This is why Wrightson ICAP also believes that the Federal Reserve may choose to stop reducing its balance sheet before RRP is completely depleted. In this way, if financing demand surges, any remaining cash in the tool can be redeployed to the repurchase market.

Crandall stated that the gradual trajectory of balance sheet normalization will provide the Federal Reserve with greater flexibility and more time to measure the impact of QT on the money market.