Financial markets will welcome a "major positive"? The Federal Reserve may end this round of balance sheet reduction by the end of this year

Against the backdrop of a weak U.S. labor market and soft consumer spending leading to a sharp rise in recession expectations, the Fed's termination of the current round of balance sheet reduction since 2022 is imminent, although the actual conclusion may ultimately depend on the pace of Fed rate cuts and the liquidity pressures facing the financing market.

Since June 2022, the Fed has been implementing a quantitative tightening policy, namely Quantitative Tightening (QT), but the pace of balance sheet reduction by the Fed has gradually slowed down this year. Some Wall Street strategists have indicated that while the pace of balance sheet reduction has indeed been reduced recently as stated by the Fed, the likelihood of a sudden announcement of the end of balance sheet reduction in a "sudden brake" fashion is unlikely.

Many well-known strategists on Wall Street believe that the Fed's balance sheet reduction process is unlikely to be abruptly declared over. Previously, Fed policymakers had hinted to some extent that the Fed's process of reducing U.S. Treasury holdings would be completed by the end of the year. However, recent data indicates a significant slowdown in U.S. economic growth, possibly even entering a recession, as well as related risks of liquidity pressures in the U.S. financial markets - a point that has become very apparent in the U.S. financial system, leading investors to doubt the prospects of Fed balance sheet reduction and believe that the reduction may be about to be announced as ending.

Regarding liquidity pressures in the financial markets, on Tuesday, the funds invested by market participants in the Fed's overnight reverse repurchase agreement (RRP) tool fell below $300 billion for the first time since 2021, hitting the lowest level in over three years for two consecutive days since May 2021. Banks, government-supported enterprises, and money market mutual funds use this tool to earn interest income. According to data from the New York Fed, the latest data has dropped significantly compared to the record $25.54 trillion on December 30, 2022.

Strategists are closely monitoring the pace of consumption of this mechanism called RRP. Some Wall Street strategists have warned that the consumption of this mechanism indicates that excess liquidity in the financial system is being significantly drained, and bank reserve balances are not as ample as Fed policymakers believe.

If the goal is to stimulate the economy, the Fed's combination of loose policies may be to stop balance sheet reduction + rate cuts

"If the Fed's goal is to stimulate U.S. economic growth through rate cuts, then balance sheet reduction (QT) may also stop." Mark Cabana and Katie Craig, market strategists at the major Wall Street bank Bank of America, wrote in a report to clients on Wednesday. "If the Fed's goal is simply to achieve policy normalization, then QT may continue."

More and more economic indicators suggest that the slowdown in U.S. economic growth is much faster than expected by Fed policymakers a few weeks ago, especially as the U.S. unemployment rate unexpectedly rose to 4.3%, triggering the "Sam Rule" with a 100% accuracy rate in predicting economic recessions. The rise in U.S. recession expectations has sparked a sharp rise in global bond markets on Monday, as bond traders bet that the Fed and other central banks will take more aggressive measures in rate cuts to boost economic growth.

The global repricing in global bond markets has been so drastic that at one point, the interest rate swap market was betting with a 60% probability on the Fed making an emergency rate cut within the next week, indicating that the market's expected timing for rate cuts is much earlier than the next scheduled meeting in September The current pricing of swaps indicates that the Federal Reserve is likely to cut interest rates by 50 basis points in September, rather than the 25 basis points bet before the July unemployment rate announcement. At the same time, the swap market is also betting on a further 50 basis point rate cut in November and a 25 basis point cut in December.

The market is also concerned about the liquidity of the U.S. financial system, and how much the Federal Reserve's $7.2 trillion asset-liability portfolio can continue to shrink before worrying liquidity cracks (similar to those that appeared before the severe funding shortage five years ago) begin to emerge.

In the past, Federal Reserve policymakers have discussed the possibility of not stopping the balance sheet reduction process when they start cutting interest rates. However, the U.S. economy may be heading into a recession, especially as the sudden downturn in the labor market threatens a smooth policy transition, with the current labor market being the Fed's primary focus. In addition, giants like Disney (DIS.US) and Hilton (HLT.US) have recently issued warnings together, signaling an impending storm of U.S. household consumption contraction, casting a heavy fog over the prospect of a "soft landing" for the U.S. economy.

Powell stated in a recent speech after the latest rate decision that officials are now more focused on the other side of the dual mandate, as the inflation rate has dropped significantly from its peak during the pandemic. The Fed hopes to prevent undue harm to the U.S. labor market. In other words, the number of non-farm payrolls and the unemployment rate in the U.S. are currently the Fed's main focus, so a weak U.S. labor market will undoubtedly push the Fed to start an interest rate cut cycle in September. Therefore, in the eyes of some analysts, the Fed's rate cut in September is only a matter of time before it is officially announced.

Furthermore, as more Americans struggle to find work, the lack of strong income support means that U.S. consumer spending is likely to enter negative growth territory. A decline in consumer spending will undoubtedly have a serious negative impact on the U.S. economy, given that 70%-80% of the components of the U.S. GDP are closely related to consumption.

If the Fed stops this round of balance sheet reduction, global financial markets may see a "liquidity bonanza"

Although the current reserves of up to $3.37 trillion (the highest level in nearly two months) are generally considered sufficient, a significant reduction in reserves by the Fed could trigger volatility in the overnight financing market, similar to the financial system liquidity crisis in September 2019. The Fed, which has been reducing its balance sheet since June 2022, has recently slowed down the pace of reduction to alleviate potential pressure on money market rates.

Nevertheless, as indicated by the RRP mechanism, there are still signs of pressure in the financing sector of the financial system. With an increase in the issuance of U.S. government bonds and primary dealers holding near-historic levels of U.S. Treasury securities, overnight repurchase agreement (loans collateralized by government bonds) rates are rising At the same time, the balance of the Federal Reserve's overnight reverse repurchase (RRP) tool, which is considered an indicator of excess liquidity in the financial system, dropped to $287 billion every trading day this month, the lowest level in over three years. On Thursday, this number slightly increased to $303 billion.

Even as funding pressures intensify, the Federal Reserve has taken supportive measures to address potential tensions, including providing sponsored repurchase agreements that offer relatively easy access to funding sources, as well as the Fed's standing repurchase agreement tool, which allows eligible institutions to borrow cash at rates up to the upper limit of the Fed's policy target range in exchange for treasuries and agency debt.

Barclays Bank strategist Joseph Abate stated that repo rates would have to rise further before actively using this tool. "Two possible drivers that could prompt the Fed to suddenly announce an end to the QT program: showing signs of monetary market liquidity exhaustion, or a U.S. economic recession," wrote Morgan Stanley strategists Seth Carpenter, Matthew Hornbach, and Martin Tobiassen. "But we believe that neither of these outcomes is likely, making it difficult for the Fed to suddenly announce the end of QT."

Typically, when the Federal Reserve directly buys bonds (quantitative easing, QE) or stops shrinking its balance sheet (halting the process of reducing assets and liabilities), both actions mean that financial market liquidity will be significantly boosted. When the Fed buys bonds, it is essentially exchanging bonds held by banks for cash. This cash is deposited into the banking system in the form of bank reserves, increasing the money supply within the banking system. This means that banks can provide more loans, thereby promoting investment and consumption. By purchasing long-term bonds, the Fed raises the prices of these bonds, lowering their yields (i.e., long-term interest rates in the financial markets), and lower long-term rates encourage borrowing by businesses and consumers, stimulating economic activity.

Halting the balance sheet reduction means that the Fed will no longer reduce its balance sheet but will continue to hold or repurchase maturing bonds. When the Fed stops shrinking its balance sheet, the level of reserves in the banking system will not decrease, and may even increase significantly, meaning that liquidity in the market tends to loosen, and banks' lending capacity greatly improves.

Fed balance sheet reduction typically leads to high expectations for long-term interest rates, as the supply of bonds in the market increases. Halting the balance sheet reduction avoids the pressure of rising expectations for long-term interest rates in the U.S., and the financial system will continue to support economic activity. Therefore, by directly buying bonds or announcing a halt to balance sheet reduction, the Fed's monetary policy influence and expectation management mechanisms are sufficient to significantly expand the liquidity of the financial system, lower long-term rates, boost prices of risky assets such as stocks, and stimulate the economy by enhancing market confidence