Fed's balance sheet runoff in focus as bank reserves are ebbing

Prolonged funding pressures in US money markets, just as bank reserves held at the Federal Reserve are dwindling, suggest the central bank may be getting closer to ending the unwinding of its massive portfolio of securities. 

Overnight funding markets, where banks and asset managers borrow and lend to each other on a day-to-day basis, have been volatile since the beginning of September. Ultra-short-term interest rates, which have been steadily rising as the Treasury is rebuilding its cash pile, remain stubbornly elevated even after a benign quarter end. 

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As a result, the gap between the Secured Overnight Financing Rate and the effective fed funds rate — the central bank's benchmark rate — is near its widest level since the end of 2024. Meanwhile, bank reserves fell just below $3 trillion, the lowest level since January, according to the latest data.

Fed Chair Jerome Powell said last month bank reserve balances are still "abundant" and have yet to reach the minimum level needed to cushion against market disruptions, though he acknowledged they're getting closer. Fed Governor Christopher Waller earlier estimated that level — known as ample — at $2.7 trillion. 

With market metrics showing that funding costs are getting tighter, market observers say that level is fast approaching. 

"While this development was not unexpected, it suggests that reserves are close to becoming merely ample – rather than abundant," John Velis, a foreign-exchange and macro strategist at BNY, wrote in a note to clients on Tuesday. "The current challenge facing the Fed is assessing where that change in the demand curve for liquidity will occur."

Fed officials have since 2022 been winding down the central bank's balance sheet — a process known as quantitative tightening — reversing trillions of dollars of asset purchases designed to stimulate the economy after the pandemic struck. Earlier this year, the Fed slowed the pace by reducing the amount of bond holdings it lets roll off every month. 

The minutes of the Federal Open Market Committee's Sept. 16-17 gathering due Wednesday could show where the central bank stood on the issue after cutting its benchmark rate by a quarter percentage point last month. 

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A flurry of Treasury bill issuance after the government raised the debt ceiling earlier this summer has lured away cash, dragging yields higher across a range of instruments. Interest-rate benchmarks tied to overnight repurchase agreements collateralized by US Treasuries are hovering around the Fed's interest on reserve balances rate, known as IORB, an indication that higher funding costs are here to stay. 

Dallas Fed President Lorie Logan has said using the spread between IORB and the Tri-Party General Collateral Rate (TGCR), a risk-free overnight rate that underpins more than 1 trillion in daily transactions, might provide a cleaner read on liquidity conditions and the state of bank reserves.  

In a speech in August, Logan noted that US repo rates were on average about 8 basis points below interest on reserves in recent months, which suggested officials still had room to reduce reserves. However, for the past week TGCR has set above IORB. It fell to 4.13% as of Oct. 6 from 4.16%, New York Fed data show. IORB stood at 4.15%.   

Central bank officials appear divided on how much the Fed should tighten its balance sheet. Fed Vice Chair for Supervision Michelle Bowman said at the end of September the Fed should seek to achieve the smallest balance sheet possible, with reserve balances at a level closer to scarce than ample. That's in contrast with Powell, Logan and others who have suggested that the runoff should end once reserves are near ample, likely by the end of this year. 

"We should hear more about the possibility that reserves are indeed transitioning from abundant to merely ample," Velis said.