Wall Street's biggest banks shifted ahead of last month's Federal Reserve meeting toward predicting the U.S. central bank would end its balance sheet reduction process later this year than previously thought, according to a survey released on Thursday by the New York Fed.
Banks, referred to as primary dealers, now believe the process known as quantitative tightening, or QT, will end in the fourth quarter, according to a poll taken ahead of the Fed's Dec. 12-13 policy meeting. In the primary dealer survey done ahead of the policy meeting that ended on Nov. 1, the banks collectively viewed the third quarter as the stopping point for QT.
If the dealers are right, the Fed's balance sheet will contract to $6.75 trillion from the current level of about $7.764 trillion. The dealers also predicted ahead of the December meeting that there would be $375 billion in the central bank's reverse repo facility when QT ended, versus the expected $625 billion in the October survey.
In the December survey, respondents said they expected bank reserves to be at $3.125 trillion at the end of QT, versus $2.875 trillion in the prior poll.
The QT process has complemented the rate hikes delivered by the Fed as part of its effort to lower inflation back to its 2% target. The central bank aggressively bought Treasury bonds and mortgage-based securities at the start of the coronavirus pandemic in the spring of 2020, causing its overall holdings of cash and bonds to more than double to around $9 trillion by the summer of 2022. The Fed has been shrinking its holdings since last year, but has not given much guidance about how long the process will play out.
Minutes from the Fed's meeting last month, which were released on Wednesday, noted that some officials are now ready to talk about the how and when of ending QT. The question has been on the minds of investors and traders given the apparent end of the current rate hiking cycle and rising bets in financial markets that the central bank will be cutting rates as soon as next spring as inflation pressures wane.
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The challenge for the Fed in dialing back stimulus is that it is trying to achieve a level of liquidity in the financial system that will allow it to retain control over short-term rates, with a cushion to deal with the volatility that can often strike money markets. But there's no clear sense so far on how to measure the needed amount of liquidity.
Michael Feroli, chief U.S. economist at J.P. Morgan, said in a note on Wednesday that more guidance on the QT endgame will be forthcoming soon. Given the nascent debate seen in the minutes of the December meeting, "we suspect this means that we could see a fuller discussion of potential balance sheet plans in the minutes" of the next Fed policy meeting, which takes place later this month, he said.
Barclays economists said they expected money market rates like the federal funds rate and the Secured Overnight Financing Rate, will loom large in the Fed's thinking.
They also believe the Fed may be more cautious about testing how far it can go with running down the balance sheet relative to the view of primary dealers ahead of the December policy meeting, saying in a note that "we look for the Fed to err on the side of caution" and end QT in June or July before any signs of stress emerge.
Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, also thinks QT will end sooner than the survey suggests based on the meeting minutes. "There is now a compelling argument that the balance sheet rundown will be ended prior to the first cut of the cycle," he said in a note to clients.
