By Michael S. Derby

(Reuters) – Wall Street's largest banks predict that the Federal Reserve will conclude its balance sheet reduction by April next year, maintaining their July assessment.

The banks anticipate the Fed's balance sheet will stabilize at $6.4 trillion, significantly above the pre-pandemic level of $4.2 trillion. This information comes from a survey of primary dealers conducted by the New York Fed prior to the recent Federal Open Market Committee (FOMC) meeting. These banks act as counterparties to Fed policy operations.

According to the survey, "Most dealers indicated they expected the end of balance sheet reduction to be determined by assessments of reserve levels, overnight reverse repo take-up, or upward pressure on money market rates relative to administered rates." Some dealers noted that macroeconomic factors might influence their outlook regarding the end of the runoff.

The survey was released a day after the Fed published minutes from the September 17-18 FOMC meeting, which provided limited new insights about the balance sheet outlook. Officials emphasized that the ongoing reduction could persist even as they adjust the Fed's interest rate target.

Recent Fed announcements come amid market participants grappling with unexpected volatility at the end of the third quarter. September 30 saw significant fluctuations in short-term rates and the initial actual use of the Fed’s Standing Repo Facility (SRF), a liquidity tool, although conditions soon normalized.

For over two years, the Fed has decreased its Treasury and mortgage bond holdings through a process known as quantitative tightening (QT). This process has resulted in a drop from a peak of $9 trillion in the summer of 2022 to the current $7.1 trillion.

For much of this reduction, QT has effectively tightened monetary policy alongside Fed rate hikes, aimed at combating high inflation. However, with inflation pressures easing, the Fed recently reduced its overnight target rate by half a percentage point, leading some market players to question the necessity of continuing balance sheet reductions.

Fed officials underscore that balance sheet management is independent from interest rate policies, which are the primary tool for monetary policy. They reaffirm the ongoing drawdown will persist as long as excessive liquidity exists in the financial system, even without a clear timeline for when this balance will be achieved.

“Reserves are still abundant and expected to remain so for some time,” stated Fed Chair Jerome Powell after the September meeting. “What that tells you is, we’re not thinking about stopping runoff,” despite rate cuts.

Market conditions are currently being tested. On September 30, short-term rates were notably volatile, and market participants significantly exchanged eligible bonds with the Fed for cash using the SRF.

This situation appears reminiscent of September 2019 when the Fed ended its QT due to interest rate volatility, but unlike then, the Fed maintained control over the federal funds target rate.

Last week, the effective fed funds rate held steady at 4.83%, comfortably within the targeted range of 4.75%-5.00%. In contrast, rates in 2019 had exceeded the established target range. Last week, rates for general collateral overnight repo transactions increased by 9 basis points, the highest climb in about 11 months, but have since reverted to previous levels.

Many analysts distinguish this latest turbulence from events five years ago. According to analysts at Wrightson ICAP (LON:NXGN), “Last week’s rate spike was purely a function of dealer balance sheet constraints rather than broader banking sector liquidity issues,” emphasizing that reserve balances remained stable.

Some market participants argue that increasingly tighter conditions in the repo market could prompt the Fed to conclude QT sooner than expected. The meeting minutes indicated that Fed officials monitor market conditions for signs of liquidity shortages, paying particular attention to repo market activity.

The minutes recognized that indicators suggest reserves remain "abundant," while also noting increased repo market rates linked to substantial Treasury debt sales. The Fed official tasked with implementing monetary policy highlighted the connection between the repo market and the federal funds rate, underscoring the importance of monitoring various indicators to assess reserve levels and the money market's health.