At a time when the US labor market and weak consumer expenditures have led to a sharp rise in market recession expectations, the end of this round of balance sheet contraction by the Fed 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 begun implementing quantitative tightening (QT), but the Fed's balance sheet contraction process has gradually slowed this year. Some Wall Street strategists say that although the pace of contraction has indeed been reduced as stated in the Fed's recent statement, the possibility of an "emergency stop" announcement is unlikely.

Many well-known Wall Street strategists believe that the Fed's balance sheet contraction process is unlikely to be formally declared over suddenly. Previously, Fed policymakers have hinted that the process of Fed reducing holdings of Treasury bonds will be completed by the end of the year. However, recent data shows that the US economic growth has significantly slowed down, and even is likely to have entered a recession, as well as the related risks of liquidity pressure in the US financial market - which is already very obvious in the US financial system - which has made investors skeptical about the prospects of Fed's balance sheet contraction and believe that it may soon be announced to end.

As for liquidity pressures in financial markets, on Tuesday, market participants invested in the Fed's overnight reverse repurchase agreement tool (RRP) fell below 300 billion US dollars for the first time since 2021, and hit the lowest level in more than three years since May 2021 for two consecutive days. Banks, government-supported businesses, and money market mutual funds use the tool to earn interest income. According to data from the New York Fed, the latest data has dropped significantly compared to the record of 2.554 trillion US dollars on December 30, 2022.

Strategists are closely watching the consumption rate of this mechanism, called the RRP. Some Wall Street strategists warn that the depletion of this mechanism indicates that the surplus liquidity in the financial system has been greatly reduced, and the bank reserve balance is not as sufficient as Fed policymakers think.

If the goal is to stimulate the economy, the combination of Fed's flexible policies may be to stop the balance sheet reduction and cut interest rates.

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

More and more economic indicators show that the slowdown in US economic growth is much faster than what Fed policymakers expected a few weeks ago, especially the unexpected increase of US unemployment rate to 4.3%, triggering the "Sam rule" with an accuracy rate of 100% in predicting the economic recession. The rise in US recession expectations has led to a large increase in the global bond market on Monday as bond traders bet that the Fed and other central banks will take more aggressive measures on interest rate cuts to boost economic growth.

The global repricing of the global bond market was so dramatic that the interest rate swap market once bet that the Fed is likely to cut interest rates urgently within the next week of 60%, which means that the expected time point for interest rate cuts is far earlier than the scheduled meeting in September. The current price of the swap contract shows that the Fed is likely to cut interest rates by 50 basis points in September, instead of betting on 25 basis points before the announcement of the July unemployment rate, and the swap market also bets on a further 50 basis points in November and 25 basis points in December.

The market is also concerned about the liquidity of the US financial system, and how much the Fed’s $7.2 trillion asset and liability portfolio can continue to shrink before the liquidity crack (similar to the liquidity crack before the severe funding shortage five years ago) may begin to appear.

In the past, Fed policymakers have discussed the possibility that they do not need to stop the balance sheet contraction process when they start lowering interest rates. However, the US economy may enter a recession, especially the sudden decline in the labor market threatening the smooth transition of policies. The labor market is currently the focus of the Fed’s attention. In addition, giants like Disney (DIS.US) and Hilton (HLT.US) have recently issued a joint warning that the storm of tightening of US household consumption is coming, and the prospect of a "soft landing" for the US economy is shrouded in uncertainty.

Powell stated in a speech after the latest interest rate decision that as inflation has fallen significantly from the pandemic peak, officials are now more focused on the other side of the dual mandate, which is to prevent undue harm to the US labor market. Namely, the number of non-farm employment and the unemployment rate in the United States are the most important data for the Federal Reserve at present. Therefore, the weak US labor market will undoubtedly drive the Federal Reserve to initiate a rate cut cycle in September. In the view of some analysts, the Federal Reserve's rate cut in September is only waiting for the official announcement.

In addition, as more and more Americans cannot find work, the consumption of US consumers will soon fall into negative growth territory without strong income support. The decline in consumer spending will undoubtedly have a serious negative impact on the US economy. After all, 70% to 80% of items in the US GDP composition are closely related to consumption.

If the Federal Reserve stops this round of balance sheet reduction, the global financial market may usher in a "liquidity bonanza".

Although the current reserve of up to $3.37 trillion is generally considered sufficient, if the Federal Reserve significantly reduces the reserves, it may cause volatility in the overnight financing market, similar to the liquidity crisis in the financial system in September 2019. The Federal Reserve, which has been reducing its balance sheet since June 2022, has recently slowed down its pace of balance sheet reduction to ease potential pressure on monetary market interest rates.

Nevertheless, as implied by the RRP mechanism, there are still signs of pressure in the financing sector of the financial system. As US government bond issuance increases and primary traders hold US Treasury bonds close to the highest level in history, the overnight repurchase agreement (a loan collateralized by government bonds) interest rate is rising.

At the same time, the balance of the Federal Reserve's overnight reverse repurchase tool (RRP), which is seen as an indicator of excess liquidity in the financial system, has fallen to the lowest level in more than three years on each trading day this month, reaching $287 billion. On Thursday, this figure rose slightly to $303 billion.

Barclays strategist Joseph Abate said that before actively using the tool, the repo rate will have to continue to rise. Morgan Stanley strategists Seth Carpenter, Matthew Hornbach, and Martin Toews wrote, "Two possible driving factors may prompt the Federal Reserve to suddenly declare the end of the QT plan: the presentation of a monetary market liquidity famine or a US economic recession." But we believe that neither of these results is likely to occur, so it is difficult for the Federal Reserve to suddenly announce the end of QT.

Generally speaking, the Federal Reserve directly buying bonds (i.e. quantitative easing, abbreviated as QE) or stopping balance sheet reduction (i.e. stopping the reduction process of assets and liabilities) both mean that financial market liquidity will be greatly oversupplied. When the Federal Reserve purchases bonds, it is actually exchanging the bonds held by banks for cash. These cash reserves are stored in the banking system in the form of bank reserves, increasing the supply of funds in the banking system. This means that banks can provide more loans, thus promoting investment and consumption. By purchasing long-term bonds, the Federal Reserve has pushed up the prices of these bonds and reduced their yields (i.e. long-term interest rates in the financial market), and lower long-term interest rates encourage businesses and consumers to borrow, stimulating economic activity.

Stopping balance sheet reduction means that the Federal Reserve will no longer reduce its assets and liabilities, but continue to hold or repurchase bonds that have matured. When the Federal Reserve stops reducing its balance sheet, the level of reserves in the banking system will not decrease, and may even rise substantially. This means that the liquidity of the market tends to be loose, and the bank's lending capacity will also be greatly improved.

The Federal Reserve's balance sheet reduction usually leads to high expectations for long-term interest rates, because the supply of bonds on the market increases. Stopping balance sheet reduction avoids the pressure of rising expectations for long-term interest rates in the United States, and the financial system will continue to support economic activities. Therefore, by directly buying bonds or announcing the end of balance sheet reduction, the Fed's monetary policy influence and expectation management mechanism are enough to expand the liquidity of the financial system, lower long-term interest rates, boost the prices of risk assets such as stocks, and stimulate the economy by enhancing market confidence.

Editor/ping