The pressure in the U.S. money market sounds the alarm, and the Federal Reserve's balance sheet reduction may be nearing its end

The ongoing funding pressure in the U.S. money market, along with the gradual reduction of reserves at the Federal Reserve, indicates that the Federal Reserve may soon end its large-scale balance sheet reduction plan. Since early September, the spread between the Secured Overnight Financing Rate (SOFR) and the Federal Reserve's benchmark interest rate has approached its highest level since the end of 2024, which is a key indicator of short-term financing costs. Additionally, Wall Street Insight has mentioned that U.S. bank reserves have also fallen below $3 trillion, reaching a new low since January. These signs indicate that excess liquidity in the U.S. financial system is being rapidly absorbed. However, there seems to be a divergence within the Federal Reserve regarding when to stop the balance sheet reduction. The upcoming release of the Federal Reserve's September meeting minutes this Thursday may provide more clues about the decision-makers' stance on this issue. Continued Pressure in the Funding Market The ongoing loss of liquidity in the current financial system primarily stems from the combination of two major factors. First, the Federal Reserve continues its quantitative tightening process, allowing its held bonds to mature without reinvestment, which directly withdraws funds from the financial system. Due to the potential for QT to exacerbate liquidity constraints and lead to market turmoil, the Federal Reserve has slowed its pace of balance sheet reduction earlier this year. Second, after resolving the debt ceiling issue in July, the U.S. Treasury significantly increased debt issuance to rebuild its cash balance, causing short-term interest rates to continue rising and remain elevated even after the quarter-end. This has directly led to a series of interest rate benchmarks related to U.S. Treasury collateralized repurchase agreements, such as the Secured Overnight Financing Rate (SOFR), lingering near the Federal Reserve's Interest on Reserve Balances (IORB), indicating that higher financing costs may persist. As the pressure of liquidity tightening increasingly manifests in commercial banks' reserve accounts, data shows that the decline in cash assets held by foreign banks is even faster than that of domestic U.S. banks. Alternative Indicators Sending Warning Signals Some Federal Reserve officials have suggested focusing on indicators that better reflect liquidity conditions. According to Wall Street Insight, Dallas Fed President Lorie Logan has stated that by observing the spread between the Interest on Reserve Balances (IORB) and the Tri-Party General Collateral Rate (TGCR), a clearer understanding of liquidity conditions can be obtained. In a speech in August, Logan pointed out that in recent months, U.S. repo rates have averaged about 8 basis points lower than the reserve rate, indicating that officials still have room to reduce reserves. However, according to data from the New York Fed, in the past week, the TGCR has risen above the IORB, which is a clear tightening signal. As of October 6, the TGCR fell from 4.16% to 4.13%, while the IORB was at 4.15% Discrepancies Within the Federal Reserve Emerge The Federal Reserve's goal is to reduce its balance sheet as much as possible without triggering market turmoil. The current core debate revolves around how to define the "comfort zone" for reserve levels. Powell believes that bank reserve balances are still in a "plentiful" state and expects the balance sheet reduction to continue until reserves fall to "adequate" levels. Although he acknowledges that we are getting closer to this level, he has not provided a clear signal to stop. Previously, Federal Reserve Governor Waller estimated that the "adequate" level is around $2.7 trillion. The Vice Chair for Financial Supervision Bowman stated at the end of September that the Federal Reserve should seek to achieve the smallest possible balance sheet, bringing reserve balances closer to "scarce" rather than "adequate." This represents a more hawkish stance. The market is closely watching the FOMC meeting minutes to be released early Thursday morning for more clues regarding this debate. As John Velis, a foreign exchange and macro strategist at BNY Mellon, pointed out: The challenge currently facing the Federal Reserve is assessing where the turning point in the liquidity demand curve will appear. We should hear more discussions about reserves indeed transitioning from "plentiful" to merely "adequate."