When will the Fed stop shrinking its balance sheet? Goldman Sachs: It will start "hitting the brakes" in Q3 next year and end in Q1 2015.

As the Federal Reserve's interest rate hike cycle approaches its end, the process of balance sheet reduction has also attracted much attention.

The Federal Reserve officially announced at the FOMC meeting in May last year that it would begin reducing its balance sheet from June 1st until November 1st. Over the course of 18 months, the Federal Reserve's balance sheet has been reduced by about $1.04 trillion to $7.8 trillion, a decrease of approximately 11.76%. The breakdown is as follows:

• Holdings of U.S. Treasury bonds decreased from $5.7708 trillion to $4.8726 trillion, a decrease of $898.2 billion, or 15.6%.
• Holdings of federal agency debt securities remained unchanged (as they already accounted for a small proportion).
• Mortgage-backed securities (MBS) decreased from $2.7074 trillion to $2.4639 trillion, a decrease of $244.9 billion, or 9%.
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So, when will the Federal Reserve stop reducing its balance sheet?

On November 19th, a team led by Jan Hatzius, Chief Economist at Goldman Sachs, stated in a report that in 2022, balance sheet reduction will mainly be achieved by reducing bank reserves, while in 2023, it will mainly be achieved by reducing the size of the Federal Reserve's overnight reverse repurchase (ON RRP) accounts, which can be understood as a reservoir of idle funds for non-bank institutions.

Hatzius believes that from the Federal Reserve's perspective, when bank reserves change from "ample" to "sufficient," it also means that changes in reserve supply will have a moderate impact on short-term interest rates, and the FOMC may stop reducing its balance sheet.

Goldman Sachs estimates that short-term interest rates will become more sensitive to changes in reserves around the third quarter of 2024, and it is expected that the Federal Reserve will begin to slow down the pace of balance sheet reduction:

• In the fourth quarter of 2024, it is expected that the Federal Reserve will halve the monthly reduction limit for Treasury bonds from $60 billion to $30 billion, and halve the monthly reduction limit for MBS securities (mortgage-backed securities) to $17.5 billion.

Goldman Sachs predicts that the Federal Reserve's balance sheet reduction will be completed in the first quarter of 2025, at which time bank reserves will account for 12-13% of bank assets (currently 14%), amounting to approximately $2.9 trillion (currently $3.3 trillion), and the Federal Reserve's balance sheet will account for about 22% of GDP (currently about 30%, approximately 18% in 2019).

According to Goldman Sachs, based on model predictions, if the Federal Reserve permanently reduces its holdings of 10-year Treasury bonds equivalent to 1% of nominal GDP, it generally corresponds to an increase of about 2 basis points in the 10-year Treasury bond yield. Therefore, the overall impact of this balance sheet reduction is expected to be about 25 basis points on the 10-year Treasury bond yield, which is slightly lower than the effect of a single interest rate hike, and a large part of the impact of balance sheet reduction has already been priced into the bond market. The current key risk is that the increase in US debt supply in 2024 may lead to significant volatility in the US Treasury market, which could cause the Federal Reserve to stop tapering its balance sheet earlier in order to avoid market turbulence.

It is expected that the Federal Reserve's future balance sheet reduction will continue to be achieved by reducing the size of overnight reverse repurchase agreements (ON RRP). In 2022, the reduction in the Federal Reserve's balance sheet mainly came from the decrease in bank reserves. Starting in 2023, the tapering will be accomplished by reducing the size of ON RRP. Looking ahead, it is expected that the RRP balance will continue to decline and reach near-zero levels in 2024. The decline in RRP balance accounts for the majority of the expected scale of the Federal Reserve's balance sheet reduction in the next year:

According to our data, the size of bank reserves decreased from $4.3 trillion (about 19% of bank assets) in 2021 to around $3.1 trillion (about 13.5% of bank assets) in December 2022.

At the same time, the size of the Federal Reserve's reverse repurchase agreements (RRP) increased in 2022. This is because non-bank institutions cannot deposit reserves with the Federal Reserve, but they can engage in ON RRP transactions with the Federal Reserve. Therefore, when non-bank institutions sell securities assets, it may lead to an increase in deposits held by non-bank institutions in banks, thereby increasing reserves.

However, the situation changed in 2023, with reserve balances remaining relatively stable, and the Federal Reserve's balance sheet reduction process was achieved by reducing the use of RRP tools.

We expect that by the end of this year, the RRP balance will have decreased by more than $1.5 trillion to $936 billion.

It is expected that the tapering will end in the first quarter of 2025 when bank reserves transition from "abundant" to "sufficient". This also means that changes in reserve supply will have a moderate impact on short-term interest rates, and the FOMC may stop tapering:

To assess when reserves and broader money market conditions are likely to begin exerting upward pressure on short-term interest rates, we use a reduced-form regression model that predicts the spread between the effective federal funds rate and the interest on reserves rate (IORB) based on the ratio of reserves to bank assets, our forecast of bill supply, and the demand for short-term funding by leveraged investors (proxied by Treasury futures short positions).

Our model suggests that short-term interest rates will become more sensitive to changes in reserves around 2024Q3, and we expect the FOMC to start considering changing the pace of tapering at that time. In 2024Q4, the pace of balance sheet reduction will slow down, with the monthly cap on Treasury tapering reduced from $60 billion to $30 billion, and the monthly cap on MBS securities tapering reduced from $35 billion to $17.5 billion. Goldman Sachs predicts that bank reserves will account for 12-13% of bank assets (currently 14%), or about $2.9 trillion (currently $3.3 trillion). The Federal Reserve's balance sheet will account for about 22% of GDP (currently about 30%, and 18% in 2019):

By 2025, the total assets of the Federal Reserve will shrink to $6.5 trillion, with a reduction of $2.5 trillion. The size of US Treasury bonds will shrink to $3.9 trillion, with a reduction of $1.9 trillion. The size of mortgage-backed securities (MBS) will shrink to $1.9 trillion, with a reduction of $770 billion.

The Impact of Another $1.5 Trillion Balance Sheet Reduction by the Federal Reserve

Analysts point out that overall, the market has shown resilience so far, thanks to the ample liquidity in the global financial system since the outbreak of the COVID-19 pandemic. However, further balance sheet reduction in the future may become more challenging, as the process may be accompanied by an accelerated pace of US Treasury bond supply.

Earlier, it was reported that the Federal Reserve plans to reduce its balance sheet by another $1.5 trillion by mid-2025. This tightening monetary policy stance comes at a time when the US government is significantly increasing its debt issuance and foreign investors' demand for US Treasury bonds is weakening. This could push up borrowing costs for the US government and corporations, and potentially cause losses for many investors who had bet on a bull market in US Treasury bonds earlier this year due to the end of the interest rate hike cycle.

Goldman Sachs remains optimistic, as they still expect the Federal Reserve's future balance sheet reduction to have a more moderate impact on interest rates, broader financial conditions, economic growth, and inflation:

Based on a series of studies, our empirical rule is that if the Federal Reserve permanently reduces its holdings of 10-year Treasury bonds by an amount equivalent to 1% of nominal GDP, it will cause a rise of about 2 basis points in the 10-year Treasury yield. Therefore, the $2.5 trillion balance sheet reduction by the Federal Reserve will put upward pressure of about 20 basis points on the 10-year Treasury yield. This impact is slightly lower than that of a single interest rate hike, and a large portion of the balance sheet reduction impact is already priced into the bond market.

However, some argue that according to the Federal Reserve's research, balance sheet reduction primarily affects the term premium of long-term securities by changing their supply. A $2.5 trillion balance sheet reduction could lead to an increase of about 60 basis points in the 10-year Treasury yield, which means that the future $1.5 trillion reduction could bring about a rise of about 35-40 basis points in the 10-year Treasury yield:

If the Federal Reserve reduces its holdings of 10-year Treasury bonds by an amount equivalent to 1% of nominal GDP, it would increase the term premium of the 10-year Treasury by about 10 basis points. If the Federal Reserve accumulates a $2.5 trillion balance sheet reduction by 2025, it would be roughly equivalent to raising the policy rate by 50 basis points.

Manmohan Singh, Senior Economist at the International Monetary Fund (IMF), expects that the next $1 trillion reduction in the balance sheet will be equivalent to raising the federal funds rate by an additional 15-25 basis points.