Money market stresses "emerging" but not yet an "emergency" - BCA Research

Investing.com - The Federal Reserve is anticipated to keep assets on its balance sheet stable from next month until March, when the central bank will then begin increasing its bond holdings, according to predictions from BCA Research.

Last month, Fed Chair Jerome Powell announced the end to an era of balance sheet reduction as of December 1, saying assets will then remain steady until the Fed deems that the supply of bank reserves has fallen from "abundant" to "ample."

At that point, the Fed will begin increasing its bond holdings through what it has called Reserve Management Purchases, which involve buying government securities from the public to help manage the liquidity needed to keep the gears of the banking system well-oiled.

In a note, the BCA analysts including Ryan Swift and Robert Timper estimated that these purchases would amount to $16.4 billion per month in Treasury bills from March, saying this is "needed to stabilize the combination" of bank reserves and overnight reverse repurchase balances, or the total value of securities the Fed has sold and agreed to buy back later.

When the Fed carries out a reverse repo, it typically receives cash in exchange for those securities, essentially taking money out of the banking system.

The size of the Fed’s balance sheet is closely monitored by markets, as it determines the supply of bank reserves available and can be used by policymakers keep interest rates within their target range.

"In other words, balance sheet policy is all about keeping the supply of bank reserves at a level that makes it easy for the Fed to control interest rates," the BCA analysts wrote.

As a result, they said it was "unsurprising" that recent large movements in overnight interest rates spurred the Fed to end its longstanding policy of shrinking the enormous level of holdings currently on its books, a process known as quantitative tightening.

In October, the secured overnight financing rate rose temporarily above the Fed’s target range, pushed up by banks and other market participants seeking more cash than money markets were able to provide. Some lenders had to tap the Fed’s backstop facility to obtain financing, a signal the Fed interpreted as a sign that bank reserves may be getting uncomfortably low.

The episode also rang alarm bells for many traders, who recalled a cash crunch in 2019 which caused short-term borrowing costs to spike.

Although the situation in overnight funding markets is "not close to being" such an emergency, "the Fed is being very cautious and preemptive by responding to the first signs of money market stress," the BCA analysts said.