Liquidity alarm sounds! US Bank reserves fall below $3 trillion again, Fed's quantitative tightening may come to an end in the coming months.

The reserve money of the US banking system (a key consideration in the Federal Reserve's decision to continue shrinking its balance sheet) has once again dropped below $3 trillion. At the same time, Federal Reserve Chairman Jerome Powell signaled a possible halt to quantitative tightening (QT) in the coming months. According to data released by the Federal Reserve on Thursday, bank reserves decreased by approximately $45.7 billion in the week ending October 15, falling to $2.99 trillion. This decrease nearly offset the $54.3 billion increase from the previous week. The background of this decrease in reserves is that since the debt ceiling was raised in July, the US Treasury has increased its borrowing to rebuild cash balances. This operation will draw liquidity from other liabilities in the Federal Reserve's accounts, such as overnight reverse repos and bank reserves. As the balance of reverse repos (RRP) approaches depletion, bank reserves held at the Federal Reserve continue to decline. The decrease in cash assets held by foreign banks even exceeds that of domestic banks in the US. As the Federal Reserve continues to push forward with balance sheet reduction (i.e. quantitative tightening/QT), these flows of funds will impact the daily operations of the financial system. Due to the potential for QT to exacerbate liquidity strains and trigger market turmoil, the Federal Reserve had slowed the pace of balance sheet reduction earlier this year, reducing the monthly scale of bond rollovers allowed to expire. Powell stated on Tuesday that when bank reserves are slightly above the "ample" level recognized by policymakers (i.e. the minimum reserve size required to prevent market turmoil), balance sheet reduction will stop. He explicitly indicated that the Federal Reserve may approach this level in the "coming months", which is the strongest signal so far that the Federal Reserve believes the target is nearing. Federal Reserve Governor Christopher Waller stated in an event on Thursday that the current balance sheet size has returned to a reasonable level corresponding to "ample reserves". In July of this year, Waller estimated that the minimum ample reserve was around $2.7 trillion. "We maintain ample reserve sizes to ensure that the banking system and financial markets have enough liquidity, ultimately avoiding institutions scrambling for small amounts of funds to cover reserve positions," Waller said. "In my view, such a situation of fund scarcity is absurd." Affected by liquidity changes, the effective federal funds rate, a key target of Federal Reserve policy, saw a slight increase within the target range last week - the second increase in over two weeks, indicating that the future financial environment may tighten further. The rate currently remains within the range of 4% to 4.25% set by the Federal Open Market Committee (FOMC) after last month's rate cut. Over the past two years, this rate has hovered near the lower end of the range. Deutsche Bank noted that this week, the 75th percentile of this rate rose from 4.10% to 4.12%, suggesting that the median rate may also rise further. The federal funds market was once an important channel for overnight interbank borrowing, often used as a signal to judge whether financing conditions are tightening. However, during the financial crisis and the pandemic, massive monetary stimulus policies flooded the US banking system with dollars, leading banks to significantly withdraw from the federal funds market and instead deposit funds directly with the Federal Reserve. Currently, trading volume behind the federal funds rate has declined. On one hand, the surplus funds that non-US institutions can allocate in the market have decreased; on the other hand, the Federal Home Loan Banks, the largest lending group in this market, are redirecting more funds towards the repurchase market as repo market rates are higher.