Market Liquidity is Being Drained for a Longer Period of Time Than Expected by the Fed. Here’s Why It’s Making Wall Street Nervous

The Federal Reserve has taken a cautious approach in its communications with Wall Street, particularly concerning interest rates, the economic outlook, and inflation since the 2020 pandemic. However, some critics feel the Fed has gone too far in its transparency, with frequent updates drawing complaints that it's "talking too much."

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Yet, in contrast, the Fed has kept relatively quiet about the future of its large $7 trillion balance sheet and the level of liquidity needed to ensure stable markets. Brij Khurana, senior managing director at Wellington Management Company, noted that, earlier this year, consensus held that the Fed would end its balance sheet reduction, or "quantitative tightening" (QT), by late 2024. QT is the process where the Fed allows its asset holdings to mature without reinvestment, thus shrinking its balance sheet.

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However, recent Fed surveys of primary dealers suggest the timeline for QT has been extended. Recently, Dallas Fed President Lorie Logan, a key figure in the Fed’s balance sheet strategy, commented that liquidity levels seem "more than ample," a statement that surprised some experts, including Khurana. This is despite signs of tightening liquidity, as seen in declining reserves in the banking system and the rising use of the Fed’s overnight reverse repo facility, a liquidity measure closely watched by the market.

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Barclays rate strategist Joseph Abate suggested in September that the Fed should announce the end of QT at its November meeting, proposing that it could fully stop by December. Meanwhile, strategists at BofA Global had anticipated an end to QT when the Fed implemented its first rate cut in years. Although the Fed executed a large rate cut in September, it continues to let a portion of Treasurys and agency mortgage-backed securities roll off its balance sheet each month.

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Following both the 2007–08 financial crisis and the COVID-19 pandemic, the Fed significantly expanded its asset purchases to stabilize markets and support economic growth. This asset-buying spree led the balance sheet to balloon to nearly $9 trillion two years ago. While these measures helped alleviate the downturns, the current challenge lies in reducing the balance sheet to a more manageable level now that economic conditions have stabilized.

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To achieve a controlled balance sheet reduction, the Fed initiated a steady runoff process, with up to $95 billion in Treasurys and mortgage-backed securities allowed to mature each month at its peak. The pace has since slowed, with the Fed allowing up to $25 billion in Treasurys to mature monthly since June, while the cap for mortgage-backed securities remains at $35 billion. Fed officials describe this QT process as aiming for a "like watching paint dry" effect — an orderly, non-disruptive balance sheet reduction designed to keep market stability.

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In her October speech, Dallas Fed President Logan estimated current reserve balances at $3.2 trillion, up from $1.7 trillion in early 2020. Khurana noted that Wall Street estimates suggest the minimum level of reserves required by banks may be close to $3 trillion. Nevertheless, it remains uncertain what the Fed's exact target for reserves is, and whether it risks draining too much liquidity as QT continues. In May, the Fed acknowledged that the adequate level of reserves is still “uncertain,” stating that it would proceed cautiously with QT to avoid destabilizing markets.

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Lou Crandall, chief economist at Wrightson ICAP, observed that the Fed is not near an end to QT, and instead aims for a gradual process to shrink its balance sheet without causing market disruption. The goal, according to Crandall, is to navigate this balance sheet reduction gradually, maintaining stability until reaching the intended levels.

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Meanwhile, expectations for further Fed rate cuts are also part of the equation. The Fed is expected to cut rates by 25 basis points in its upcoming Thursday meeting, potentially bringing the policy rate to a range between 4.5% and 4.75%, with plans to gradually reduce rates to around 3.5% over the next year.

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Fed Chair Jerome Powell will likely emphasize the Fed's independence in his comments, though future economic policy could be influenced by a potential election win for former President Donald Trump. If elected, Trump has proposed additional tariffs and tax cuts, both of which could fuel inflation, potentially limiting the Fed’s ability to cut rates and increasing the federal deficit.

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Andrzej Skiba, head of U.S. fixed income at RBC Global Asset Management, cautioned that such a scenario could push the Fed to keep rates high while pausing QT to avoid exacerbating liquidity constraints. If Trump's policy plans include further tax cuts and deregulation, this could boost stock markets but create challenges for bonds.

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Another pressing issue on the Fed’s radar is the U.S. debt ceiling. Crandall noted that the QT process may intersect with the debt ceiling debate, as Congress will need to agree on a new debt limit by the January 1 deadline. If no deal is reached, the Treasury may need to draw down its general account to cover government expenses, potentially impacting liquidity and complicating the Fed’s QT strategy.

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Since Trump’s electoral win, Treasury yields have spiked, reflecting investor uncertainty and shifts in economic expectations. On Wednesday, the 10-year Treasury yield rose significantly, moving up by 13.8 basis points to 4.425%.

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Since the September rate cut, strong economic data and election-related concerns have fueled an ongoing increase in yields. Meanwhile, the U.S. stock market has rallied strongly, with the Dow Jones Industrial Average up nearly 17% for the year, the S&P 500 climbing approximately 24%, and the Nasdaq Composite up 26.5% year-to-date, according to FactSet data.

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