As the federal reserve continues to reduce its balance sheet, the usa debt ceiling issue has resurfaced, placing the federal reserve in a bind, but this time it is even trickier. The federal debt ceiling will be reinstated on January 2 next year, prompting the usa treasury to take a series of extraordinary measures, including cutting cash reserves and reducing the issuance of government bonds to maintain its borrowing capacity.

Since the usa treasury's cash balance - the treasury general account (TGA), is one of the major liabilities on the federal reserve's balance sheet, such actions will mainly boost the reserves held by banks at the federal reserve and the demand for the overnight reverse repurchase agreement (RRP) tool. This means that as the federal reserve continues to reduce the size of its balance sheet during the algo tightening (QT) process, the market will have plenty of cash.

However, once congress passes legislation to suspend or raise the debt ceiling, the usa treasury will quickly rebuild its cash balance, and this process will withdraw cash from the financial system. The transfer of funds between the market and government cash accounts has the potential to obscure some signals, which are crucial for identifying the stress caused by the federal reserve's balance sheet restructuring.

Gennadiy Goldberg, head of us interest rate strategy at t.d. securities, said: “As the debt ceiling starts to depress the TGA balance and temporarily increase the reserves in the system, the federal reserve might be blind to monitoring the effects of QT. This also increases the risk that once the debt ceiling is raised, reserves will quickly diminish, leading to a complete shortage.”

The minutes of the federal reserve's November meeting show that staff briefed the committee on the potential impacts of reinstating the debt ceiling. All of this makes it more difficult for market participants and policymakers to determine when QT will end. The minutes reveal that two-thirds of respondents in the primary dealer survey and market participant survey conducted by the new york fed expect QT to end in the first or second quarter of 2025.

In the last debt ceiling incident in 2023, the Federal Reserve had been reducing its balance sheet for less than a year, with still $2.2 trillion in overnight reverse repurchase agreements—tools seen as barometers of liquidity excess. However, once Congress suspends the ceiling, the U.S. Treasury rebuilds cash balances by increasing the issuance of government bonds, and money market funds withdraw from RRP. This time, by 2025, that number is less than $150 billion.

This means that any rebuilding of the TGA will lead to a decrease in bank reserves. Although the current size of this account is $3.23 trillion, and policymakers consider it to be a comfortable level, market observers are closely monitoring this level to assess when it will become scarce.

Additionally, morgan stanley indicated that the background of the financing market is different from the last time, increasing the risk of more volatility. Morgan Stanley strategist Martin Tobias wrote in a report prepared a year in advance that since 2023, hedge funds have significantly increased their long positions in U.S. government bonds, and the amount of collateral outside the Federal Reserve and the banking system is even higher.

Given that the U.S. Treasury will likely have to reduce bond issuance before the debt ceiling is raised or suspended, money market funds will have the incentive to keep more cash in RRP, even though private repo market rates are higher. Similar friction occurred in July when dealers' balance sheet constraints and repo limits made the use of reverse repurchase tools more difficult.

Tobias wrote, “Capacity limitations, along with counterparty risk restrictions, could push money market fund funds into RRP, hindering the liquidity redistribution process. This actually reduces the supply of repo financing as demand continues to grow.”

Despite most Wall Street strategists agreeing on when the Federal Reserve's balance sheet contraction should end—by the first quarter of 2025—it has become more difficult to determine when the U.S. government will run out of cash (the so-called X date).

Before Trump won the election, strategists initially predicted the X date to be around August 2025. Now, some say this date is more likely to come sooner, at some point in the second quarter, as the Republicans control both the White House and Congress.

Nevertheless, all these uncertainties will make it more challenging for the Federal Reserve to assess the risks of QT short-term interest rates. Strategists at royal bank of canada capital markets expect that the Federal Reserve will pause QT in the second half of 2025, and note that policymakers' statements indicate that there is still a long way to go before balance sheet reduction is complete.

Led by Steven Zeng and Matthew Raskin, strategists at deutsche bank suggest that policymakers could consider enhancing market monitoring to ensure liquidity support tools are ready, further slowing the pace of the second round of balance sheet reduction, and pausing the reduction until the debt ceiling issue is resolved, or ending the reduction early, though they believe the latter two options are unlikely.

Wells Fargo & co strategist Angelo Manolatos stated, "Expanding the balance sheet is easy. Reducing it is hard."