Fed Balance Sheet Reduction Sparks Concerns Over Liquidity Crunch in Overnight Lending Markets
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The Fed's balance sheet reduction worries some participants in overnight funding markets, which are important for setting interest rates. There are debates whether the Fed understands the level of reserves required to avoid market disruptions.
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Recent stresses in repo markets caused rates to spike, bringing back memories of September 2019 when overnight rates soared after reserve scarcity.
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It's unclear what the minimum "ample" level of reserves is. If the Fed shrinks its balance sheet too much, it could cause liquidity issues in funding markets again before realizing reserves dropped too low.
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Banks now seem less willing to shed reserves compared to the beginning of quantitative tightening, partly due to deposit outflows. This could lead the Fed halting balance sheet runoff earlier than planned.
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Increased speculation of Fed interest rate cuts could drive more crowded positioning in Treasuries, risking further spikes in repo rates heading into year-end.