Intro

The Federal Reserve’s shrinking balance sheet could have far-reaching implications for the banking sector, money markets and monetary policy. Global Head of Macro Strategy Matthew Hornbach and Martin Tobias from the U.S. Interest Rate Strategy Team discuss. 

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Matthew Hornbach: Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.

Martin Tobias: And I'm Martin Tobias from the U.S. Interest Rate Strategy Team.

Matthew Hornbach: Today, we're going to talk about the widespread concerns around the dip in reserve levels at the Fed and what it means for banking, money markets, and beyond.

It's Thursday, January 16th at 10am in New York.

The Fed has been shrinking its balance sheet since June 2022, when it embarked on quantitative tightening in order to combat inflation. Reserves held at the Fed recently dipped below [$]3 trillion at year end, their lowest level since 2020. This has raised a lot of questions among investors, and we want to address some of them.

Marty, you've been following these developments closely, so let's start with the basics. What are Fed reserves and why are they important?

Martin Tobias: Reserves are one of the key line items on the liability side of the Fed balance sheet. Like any balance sheet, even your household budget, you have liabilities, which are debts and financial obligations, and you have assets. For the Fed, its assets primarily consist of U.S. Treasury notes and bonds, and then you have liabilities like U.S. currency in circulation and bank reserves held at the Fed.

These reserves consist of electronic deposits that commercial banks, savings and loan institutions, and credit unions hold at Federal Reserve banks. And these depository institutions earn interest from the Fed on these reserve balances.

There are other Fed balance sheet liabilities like the Treasury General Account and the Overnight Reversed Repo Facility. But, to save us from some complexity, I won't go into those right now. Bottom line, these three liabilities are inversely linked to one another, and thus cannot be viewed in isolation.

Having said that, the reason this is important is because central bank reserves are the most liquid and ultimate form of money. They underpin nearly all other forms of money, such as the deposits individuals or businesses hold at commercial banks. In simplest terms, those reserves are a sort of security blanket.

Matthew Hornbach: Okay, so what led to this most recent dip in reserves?

Martin Tobias: Well, that's the good news. We think the recent dip in reserves below [$] 3 trillion was simply related to temporary dynamics in funding markets at the end of the year, as opposed to a permanent drain of cash from the banking system.

Matthew Hornbach: This kind of reduction in reserves has far reaching implications on several different levels. The banking sector, money markets, and monetary policy. So, let's take them one at a time. How does it affect the banking sector?

Martin Tobias: So individual banks maintain different levels of reserves to fit their specific business models; while differences in reserve management also appear across large compared to small banks. As macro strategists, we monitor reserve balances in the aggregate and have identified a few different regimes based on the supply of liquidity.

While reserves did fall below [$]3 trillion at the end of the year, we note the Fed Standing Repo Facility, which is an instrument that offers on demand access to liquidity for banks at a fixed cost, did not receive any usage. We interpret this to mean, even though reserves temporarily dipped below [$]3 trillion, it is a level that is still above scarcity in the aggregate.

Matthew Hornbach: How about potential stability and liquidity of money markets?

Martin Tobias: Occasional signs of volatility in money market rates over the past year have been clear signs that liquidity is transitioning from a super abundancy closer to an ample amount. The fact that there has become more volatility in money market rates – but being limited to identifiable dates – is really indicative of normal market functioning where liquidity is being redistributed from those who have it in excess to those in need of it.

Year- end was just the latest example of there being some more volatility in money market rates. But as has been the case over the past year, these temporary upward pressures quickly normalized as liquidity in funding markets still remains abundant. In fact, reserves rose by [$] 440 billion to [$] 3.3 trillion in the week ended January 8th.

Matthew Hornbach: Would this reduction in reserves that occurred over the end of the year influence the Fed's future monetary policy decisions?

Martin Tobias: Right. As you alluded to earlier, the Fed has been passively reducing the size of its balance sheet to complement its actions with its primary monetary policy tool, the Fed Funds Rate. And I think our listeners are all familiar with the Fed Funds Rate because in simplest terms it's the rate that banks charge each other when lending money overnight, and that in turn influences the interest you pay on your loans and credit cards. Now the goal of the Fed's quantitative tightening program is to bring the balance sheet to the smallest size consistent with efficient money market functioning.

So, we think the Fed is closely watching when declines in reserves occur and the sensitivity of changes in money market rates to those declines. Our house baseline view remains at quantitative tightening ends late in the first quarter of 2025.

Matthew Hornbach: So, bottom line, for people who invest in money market funds, what's the takeaway?

Martin Tobias: The bottom line is money markets continue to operate normally, and even though the Fed has lowered its policy rates, the yields on money markets do remain attractive for many types of retail and institutional investors.

Matthew Hornbach: Well, Marty, thanks for taking the time to talk.

Martin Tobias: Great speaking with you, Matt.

Matthew Hornbach: And thanks for listening. If you enjoy Thoughts on the Market, [00:06:00] please leave us a review wherever you listen and share the podcast with a friend or colleague today.