Morgan Stanley's latest research report pointed out that the Federal Reserve's reduction of its balance sheet is technically feasible, but the process will proceed slowly, primarily relying on passive balance sheet reduction. As reverse repurchase agreements are nearly exhausted, future reductions will increasingly manifest as a decline in bank reserves, potentially impacting market liquidity. However, whether long-term interest rates rise will still depend on the Treasury Department's debt issuance structure rather than the balance sheet reduction itself.
How the Federal Reserve will reduce its balance sheet in the future is becoming a focal point of market attention. In its latest research report, Morgan Stanley pointed out that changes in the size of the balance sheet may have more profound impacts compared to adjustments in policy interest rates, but the entire process will be very slow and faces several technical constraints and market trade-offs.
The report argues that the current reduction in the balance sheet mainly relies on 'passive reduction,' which means allowing the maturing U.S. Treasuries and mortgage-backed securities (MBS) to expire without reinvestment. This approach has already reduced the Federal Reserve's assets by over $2 trillion since 2022, and it is likely to remain the primary path going forward. However, as the reverse repo tool is almost exhausted, further reductions in the balance sheet will increasingly and directly reduce bank reserves, which will have a more pronounced impact on liquidity within the financial system.
The question of greatest concern to the market is whether the reduction in the balance sheet will push up interest rates. Morgan Stanley’s assessment is: not necessarily. The key lies in how the U.S. Treasury issues new debt. If more financing occurs through short-term Treasury bills rather than increasing the issuance of long-term interest-bearing Treasuries, the upward pressure on long-term interest rates may be limited.
Two Approaches to Balance Sheet Reduction: Passive Maturity and Active Sales
The report notes that there are two main ways for the Federal Reserve to reduce its balance sheet: one is passive reduction, meaning not reinvesting after securities mature; the other is actively selling assets in the market.
At present, passive reduction remains the most feasible path. Actively selling assets, especially MBS, is more challenging because it could lead to wider spreads and further worsen housing affordability. Therefore, the threshold for the Federal Reserve to actively sell MBS is very high.
At the current pace, it may take nearly a decade for the Federal Reserve to halve its MBS holdings, demonstrating that the process of reducing the balance sheet itself will be extremely slow.
The Real Constraint: Bank Reserves and Liquidity
The key limitation to further reductions in the balance sheet does not lie on the asset side, but on the liability side.
As the scale of reverse repos declines, future reductions in the balance sheet will increasingly depend on a decrease in bank reserves. However, banks have a strong demand for reserves themselves, such as regulatory requirements like the Liquidity Coverage Ratio (LCR), as well as internal liquidity management rules within banks.
If reserves decline significantly, liquidity conditions in funding markets may tighten, and volatility in the federal funds rate and repo rates could increase, potentially exceeding the interest rate on reserves. To prevent substantial fluctuations in market rates, the Federal Reserve may need to rely more on temporary open market operations to adjust liquidity.
A Technical Solution: Reducing the Balance Sheet Without Decreasing Reserves
The report also proposes a technical possibility: shrinking the balance sheet through coordination between the Treasury Department and the Federal Reserve without reducing bank reserves.
For example, the Treasury Department could reduce its Treasury General Account (TGA) balance held at the Federal Reserve. If the TGA balance decreases, the Federal Reserve could reduce its holdings of U.S. Treasuries by a corresponding amount, thereby shrinking the balance sheet while leaving the level of reserves in the banking system unchanged.
This approach may also reduce the interest payments made by the Treasury Department to the Federal Reserve, but it requires a high degree of policy coordination.
Will Balance Sheet Reduction Push Up Long-Term Interest Rates? The Key Lies with the Treasury Department
Market participants generally worry that balance sheet reduction implies an increase in bond supply, which could drive up yields, particularly long-term interest rates. However, the report argues that this relationship is not inevitable.
If balance sheet reduction is achieved through passive maturity, then the new supply is effectively managed through refinancing by the Treasury Department, as the maturity structure of government bonds is determined by the Treasury, not the Federal Reserve.
If the Treasury continues to favor issuing short-term Treasury bills rather than expanding the issuance of long-term bonds, the supply of long-term debt absorbed by the market will not increase significantly, and upward pressure on long-term interest rates may remain limited.
Overall, the Federal Reserve's balance sheet reduction is technically feasible, but the process will be gradual and constrained by factors such as banks’ reserve demand, market liquidity, and the Treasury’s debt issuance structure. For the market, what truly matters is not only the balance sheet reduction itself but also changes in the liquidity environment and interest rate structure during the process.
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Editor/Stephen
