Earlier this month, the Federal Reserve announced that it would slow the pace of its balance sheet reduction to avoid unnecessary market disruptions.
Starting June 1, the cap on Treasury securities allowed to mature without replacement will be reduced to $25 billion from the current $60 billion monthly limit. However, the $35 billion cap on monthly mortgage-backed securities (MBS) runoffs will remain unchanged, with any excess principal payments being reinvested into Treasury securities.
The adjustment in the runoff pace was largely anticipated, though there was uncertainty about whether it would be announced at this Federal Open Market Committee (FOMC) meeting or the one in June.
Also, many analysts had expected a drop in the Treasury runoff cap to $30 billion, making the decrease to $25 billion slightly surprising.
“The treasury caps will be reduced to $25 bln/mth, somewhat lower than the $30 bln/mth we had expected,” said Citi economists.
“Fed will end balance sheet reduction if they are easing policy in response to a recession. We continue to expect a recession in our base case for this year and thus we expect the Fed would end balance sheet reduction in September,” they added.
However, if economic activity remains more robust than anticipated, Citi projects that the balance sheet reduction could continue until the end of the second quarter of 2025.
Citi economists attribute this partly to the balance sheet reduction slowing more than initially expected. However, even under different Treasury General Account (TGA) scenarios and with reverse repo operations potentially draining to zero, they believe bank reserves should remain elevated throughout the year without significant increases in secured and unsecured overnight rates relative to administered rates.
Economists said they will monitor the volatility and levels of SOFR (Secured Overnight Financing Rate) and the effective federal funds rate as early indicators that reserves might be approaching ample levels.
During the week ending May 1, the Federal Reserve's balance sheet shrank by roughly $40 billion. Treasury holdings dropped by $21.9 billion, while MBS holdings decreased by $12.7 billion. Lending via the discount window saw a slight decline, and loans issued through the Bank Term Funding Program fell by $1.4 billion.
Meanwhile, a notable change on the liability side was the $17.8 billion decrease in foreign official deposits, reversing the previous week's increase. This suggests that a foreign central bank or institution needed to complete a USD transaction between April 24 and May 1. Foreign official reverse repo dropped modestly by $8 billion.
The Treasury is also reducing its cash account following significant tax-week inflows, with TGA balances down by $38.9 billion to $890 billion. A slight reduction in reverse repo led to a $45 billion increase in bank reserves, reaching $3.3 trillion.