U.S. money market pressures sound the alarm; the Federal Reserve’s balance sheet reduction may be nearing its end.

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The persistent funding pressures in the U.S. money market, as well as the gradual decline in Federal Reserve bank reserves, indicate that the Fed may be about to end its large-scale balance sheet reduction plan.

Since early September, the spread between the U.S. Secured Overnight Financing Rate (SOFR) and the Fed's benchmark rate has approached its highest level since the end of 2024. This spread is a key indicator for measuring short-term financing costs.

In addition, WallstreetCN has mentioned that U.S. bank reserves have also fallen below $3 trillion, hitting a new low since January. These signs all indicate that excess liquidity in the U.S. financial system is being rapidly absorbed.

However, there appears to be disagreement within the Fed on when to stop the balance sheet reduction. The minutes of the Fed's September meeting, to be released this Thursday, may provide more clues to the public on policymakers' stances regarding this issue.

Ongoing Stress in Funding Markets

The ongoing loss of liquidity in the current financial system is mainly due to the combination of two major factors.

First, the Fed continues its quantitative tightening process, allowing the bonds it holds to mature without reinvestment, which directly withdraws funds from the financial system. Since QT may intensify liquidity constraints and cause market volatility, the Fed slowed its balance sheet reduction earlier this year.

Second, after the U.S. Treasury resolved the debt ceiling issue in July, it sharply increased debt issuance to rebuild its cash balance, keeping ultra-short-term interest rates elevated, which have remained high even after the end of the quarter.

This has directly caused a series of rate benchmarks related to U.S. Treasury-backed repo agreements, such as the SOFR, to hover around the Fed's Interest Rate on Reserve Balances (IORB), indicating that elevated financing costs may persist.

As liquidity tightening pressure is increasingly being reflected in commercial banks' reserve accounts, data show that cash assets held by foreign banks have fallen even faster than those held by domestic U.S. banks.

Alternative Indicators Flash Warning Signals

Some Fed officials suggest focusing on indicators that better reflect liquidity conditions.

According to WallstreetCN, Dallas Fed President Lorie Logan once stated that by tracking the spread between the IORB and the Tri-Party General Collateral Repo Rate (TGCR), one can gain a clearer understanding of liquidity conditions.

In an August speech, Logan noted that in recent months, U.S. repo rates have averaged about 8 basis points below the reserve rate, indicating officials still have room to reduce reserves.

However, according to New York Fed data, in the past week, the TGCR has risen above the IORB—a clear signal of tightening. As of October 6, the TGCR fell from 4.16% to 4.13%, while the IORB was 4.15%.

Divergence Within the Fed Emerges

The Fed's goal is to reduce its balance sheet as much as possible without triggering market turmoil. The core debate now lies in how to define the "comfort zone" for reserve levels.

Powell believes that bank reserve balances are still "ample" and expects the balance sheet reduction to continue until reserves decline to a "sufficient" level. Although he acknowledges that they are getting closer to this level, he has not provided a clear signal to stop.

Previously, Fed Governor Waller estimated that this "sufficient" level was about $2.7 trillion.

Vice Chair for Supervision Bowman stated at the end of September that the Fed should aim for the smallest possible balance sheet, with reserves moving closer to "scarce" rather than "ample"—a more hawkish stance.

The market is closely watching the FOMC minutes to be released early Thursday morning for more clues regarding this debate. As John Velis, FX and macro strategist at BNY Mellon, pointed out:

The challenge facing the Fed now is to assess where the inflection point on the liquidity demand curve will emerge. We should hear more discussion about reserves indeed shifting from 'ample' to just 'sufficient'.

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