The US banking system's reserves have fallen below US$3 trillion for the first time since October 2020, marking the largest weekly decline in over two years. Bank reserves dropped by US$326 billion to US$2.89 trillion in the week through Jan 1, according to Federal Reserve data released on Thursday.

This significant decline is partly due to year-end dynamics, where banks reduce balance-sheet intensive activities like repurchase agreement transactions in order to meet regulatory requirements. This has shifted cash into places such as the Federal Reserve's overnight reverse repo facility (RRP), draining liquidity from other liabilities on the Fed's balance sheet. Between Dec 20 and 31, balances at the RRP surged by US$375 billion before falling by US$234 billion on Thursday.

Simultaneously, the Federal Reserve continues its quantitative tightening (QT) programme, removing excess cash from the financial system. At the same time, institutions are repaying loans from the Bank Term Funding Program, adding pressure to the banking system's liquidity.

As the US Federal Reserve maintains its course of QT, strategists are closely monitoring the lowest acceptable level of reserves, estimated by some to be between US$3 trillion and US$3.25 trillion, including a buffer. Policymakers have signalled that they will continue to reduce their balance sheet, with the Fed adjusting the offering rate on the RRP facility to align with the bottom of the target range for the federal funds rate. This has placed downward pressure on short-term interest rates, with some hoping it will alleviate reserve scarcity for now.

However, questions are mounting over how long the Fed can continue QT without triggering a repeat of the reserve shortage crisis that occurred in September 2019. At that time, a lack of reserves prompted a surge in key lending rates, forcing the central bank to step in and stabilise the market.

In June, the Fed lowered the cap on how much in Treasuries it will allow to mature without being reinvested, but it remains uncertain when this programme will come to a close. Adding to the uncertainty is the recent reinstatement of the debt ceiling, which complicates the task of gauging the ideal reserve level. The Treasury's actions to stay under the cap tend to inject liquidity into the system, masking potential signs of reserve scarcity.

Two-thirds of respondents to the New York Fed's Open Market Desk's surveys expect QT to end in the first or second quarter of 2025.