Not just rate cuts, Wall Street expects the Fed to pause its balance sheet reduction as well
Facing the complex economic situation in the United States, it is worth paying attention to how much more reduction pressure the Federal Reserve's balance sheet can withstand. In addition, the upcoming interest rate cut may also have a counteracting effect on balance sheet reduction
As the market anticipates the Federal Reserve to start a rate-cutting cycle, Wall Street speculates that the balance sheet reduction may also come to an end.
On Friday, Bank of America strategists Mark Cabana and Katie Craig suggested in a report to clients:
If the Federal Reserve decides to cut rates to stimulate the economy, the ongoing quantitative tightening is likely to pause;
However, if the rate cut is aimed at policy normalization, quantitative tightening may still continue.
A few weeks ago, market expectations for economic growth were relatively optimistic, but recent signs indicate that the slowdown in the economy may be exceeding expectations. This shift has triggered a massive rally in the global bond market, with traders betting on more aggressive rate cuts by the Federal Reserve and other central banks.
Market expectations for a rate cut by the Federal Reserve have sharply increased, with action likely to be taken before the September FOMC meeting. Currently, the market is pricing in a 38 basis point rate cut in September.
Facing the complexity of the economic situation, how much pressure can the Federal Reserve's massive $7.2 trillion asset portfolio withstand in terms of reduction without causing a similar funding market crack as seen five years ago is a question worth paying attention to.
Currently, the Federal Reserve's reserve balance stands at a high of $1.37 trillion, the highest level in nearly two months. The market believes this reserve level is sufficient, but if the Federal Reserve allows this amount to decrease excessively, it could trigger volatility in the overnight funding market, similar to what was experienced in September 2019. Each trading day this month, the Federal Reserve's overnight reverse repurchase agreements (RRP) have been declining, dropping to $287 billion on Thursday, the lowest level in over three years, with a slight increase to $303 billion in trading volume on Thursday.
Furthermore, once rate cuts begin, as policymakers have discussed in the past, rate cuts along with balance sheet reduction may have a counteractive effect, where a sudden economic downturn could pose a threat to a smooth transition.