Happy Monday! Welcome to our “Week at a Glance” series, where we highlight the key events and trends to watch for the week ahead.

FOMC – Thursday

The FOMC postponed its meeting to Thursday due to the election. Although the latest jobs report shows a notable slowdown, partly due to strikes and hurricanes, resulting in the weakest figures since December 2020, the Fed is likely to look past this print. Despite the noise surrounding the NFP data, the broader trend remains evident, suggesting a full rate cut on Thursday and a well-established path for continued cuts in the Fed’s cycle.

The Federal Reserve’s quantitative tightening (QT) program, which aims to reduce its balance sheet by allowing securities to roll off without reinvestment, could be approaching an unexpected early end due to mounting pressures in the liquidity markets. This surprising move would align with their evolving policy stance, as reducing the balance sheet may no longer complement the new direction toward easing. Three key indicators – the rapid decline in ON RRP (Overnight Reverse Repo) facility balances, the widening spread between SOFR (Secured Overnight Financing Rate) and the Fed Funds Rate— the recent uptick in Tern Premium – paint a picture of growing stress in short-term funding markets, making an early end to QT a logical, if unexpected, move.

The first chart, showing ON RRP usage, highlights a rapid depletion in the facility’s balances as money market funds (MMFs) shift their cash to higher-yielding alternatives, such as T-bills, spurred by the large-scale issuance from the U.S. Treasury. This withdrawal from ON RRP reduces the Fed’s ability to absorb excess liquidity, which has traditionally provided a cushion to the financial system. As balances approach critically low levels, the Fed risks losing a tool for managing short-term liquidity and preventing rate spikes. Continuing QT in this context could lead to a scenario where the Fed no longer has sufficient reserves to maintain stable short-term funding rates, raising concerns that the Fed’s tightening is inadvertently destabilizing market functioning.

The second chart, depicting the spread between SOFR and the Fed Funds Rate, offers further evidence of growing strain. When SOFR rises above the Fed Funds Rate, it signals tightening liquidity in the repo market, where institutions often rely on overnight borrowing. The recent spikes in this spread suggest that repo market stress is mounting, and with ON RRP balances depleted, the Fed has fewer tools to control SOFR effectively. If the spread between SOFR and the Fed Funds Rate continues to widen, it could reflect an increased difficulty in controlling short-term interest rates, undermining the Fed’s goal of maintaining its target range.

End of QT could also be necessitated by recent shifts in the bond market, as shown in the third chart depicting Treasury Term Premium. Over the past month, bond yields have risen sharply, reminiscent of the pattern seen around the same time last year. This “term premia frenzy” was highlighted by Chair Powell in October 2023 when he remarked on the importance of long-term bond yields in tightening financial conditions. He noted that persistent changes in financial conditions, driven by higher yields, could influence the future path of monetary policy, hinting at the Fed’s responsiveness to market-driven tightening.

In light of these developments, the Fed could unexpectedly signal an early end to QT to prevent further disruptions. Such a move would reflect the need to protect the functionality of short-term funding markets and ensure the stability of monetary policy transmission. An early end to QT, while unexpected, is a realistic response to the current conditions, balancing the Fed’s desire to ease with its responsibility to maintain orderly market conditions. 

Chart 1.a: withdrawal from ON RRP reduces the Fed’s ability to absorb excess liquidity

Chart 1.b: Repo market stress is mounting