Morgan Stanley's latest research report pointed out that constrained by banks' reserve requirements and the challenge of reducing holdings in mortgage-backed securities (MBS), the Federal Reserve’s policy landscape is unlikely to experience significant changes in the short term. Investors, on the other hand, should be wary of market volatility arising from a 'less talk, more action' approach.
As Kevin Warsh emerges as a candidate for the chair of the Federal Reserve, market attention once again focuses on the central bank's balance sheet and communication strategy. Warsh has long criticized the Fed for 'overreaching'—not only is its balance sheet excessively large, blurring the lines between monetary and fiscal policy, but its cumbersome communication framework also overly dominates market behavior.
However, Morgan Stanley's team of economists pointed out in their latest report that even if Warsh takes office, the Federal Reserve's role in financial markets is unlikely to undergo abrupt changes. The team, led by Michael Gapen, believes that any substantive shift in the Fed’s policy direction would not only take considerable time but also face insurmountable structural obstacles.
The Dilemma of 'Slimming Down'
Morgan Stanley made it clear that the logic behind the Fed's short-term interest rate decisions (Reaction Function) is unlikely to change due to a leadership transition. The firm's core view is: 'The Fed’s policy landscape is unlikely to contract rapidly.'
Although the strategy regarding the balance sheet will evolve over time, its operational mechanism is extremely complex and closely tied to the structure of the banking system. Currently, the Fed has reduced its balance sheet from approximately $9 trillion to about $6.6 trillion. However, Morgan Stanley noted that this process has mainly been achieved by depleting the overnight reverse repurchase agreement (ON RRP) balances, while the size of bank reserves—the cornerstone of the financial system—has remained largely unchanged.
The real challenge lies in the fact that if the balance sheet reduction continues, it will begin to directly erode bank reserves, causing the financial system to shift from an 'abundant' environment to a 'scarce' one, thereby pushing up short-term funding rates.
Since the 2008 financial crisis, influenced by regulatory requirements such as the Liquidity Coverage Ratio (LCR) and internal stress tests, banks' demand for reserves has remained persistently high. Morgan Stanley warned: 'While regulatory reforms could theoretically reduce this demand, thus allowing the Fed to further reduce its balance sheet, it would come at the cost of undermining the financial system's resilience. On this issue, there is no free lunch.'
A Decade-Long Endeavor
In addition to reserve constraints, the Fed’s goal of returning its portfolio to an 'all-Treasuries' configuration is destined to be a lengthy process.
Since 2022, as mortgage rates have surged, the prepayment speed of agency mortgage-backed securities (MBS) has significantly declined, markedly slowing the passive reduction of the balance sheet. Morgan Stanley estimates that even assuming a substantial decline in mortgage rates, relying solely on natural maturities and prepayments, the Fed may need close to a decade to halve its MBS holdings.
So, is there a possibility of proactive asset sales? Morgan Stanley believes the likelihood is extremely low. Actively selling assets would not only widen spreads and drain liquidity but could also undermine housing affordability and result in significant book losses for the Federal Reserve. Therefore, the Fed still has a strong incentive to avoid adopting this aggressive measure.
Market Risk
Although major reforms have been obstructed, minor adjustments may still occur.
Economists point out that the Federal Reserve can coordinate with the U.S. Treasury Department to adjust its balance sheet. The Treasury General Account (TGA) balance has now swelled to nearly one trillion dollars. If the TGA size were halved, the Fed could reduce its securities holdings without depleting bank reserves. Additionally, the Federal Reserve might gradually tilt its Treasury portfolio toward shorter-term bonds by altering the maturity structure.
Looking ahead, Morgan Stanley believes the threshold for using unconventional tools such as Quantitative Easing (QE) will significantly increase. Under the current policy preference, unless the economy falls into recession and drives interest rates to the zero lower bound, the Federal Reserve will not restart asset purchases.
Notably, Kevin Warsh has consistently opposed the Federal Reserve's 'excessive communication' approach. Morgan Stanley predicts that if he takes office, the Fed may reduce the frequency of speeches and forward guidance. This implies that investors will lose their policy 'crutch' and must increasingly rely on real-time economic data for decision-making. Such a shift could lead to heightened market volatility and higher term premiums.
Morgan Stanley concluded by reminding investors: 'While the overall policy direction is unlikely to change, shifts in market dynamics warrant close attention.'
Editor/Rocky
