The Fed Will Soon End QT to Avoid a Financial ‘Plumbing’ Problem

Fed Chair Jerome Powell is likely to announce an end to quantitative tightening this coming Wednesday. (Andrew Harnik/Getty Images)

The headlines from the Federal Open Market Committee’s policy-decision meeting this coming week will, to use journalists’ jargon, likely bury the lede.

They will dutifully report that the Federal Reserve is lowering its target for the federal-funds rate by one-quarter percentage point, from the presently prevailing 4% to 4.25% range. This will come as no surprise given that the fed-funds futures market placed a 96.7% probability on this outcome on Friday, according to the CME FedWatch site.

Far more important than that foregone conclusion is what the central bank will do with its balance sheet, a topic typically given short shrift at Fed Chair Jerome Powell’s post-FOMC press conference, which will take place this coming Wednesday afternoon. Look for the FOMC to announce an end to quantitative tightening, or QT—its systematic reduction of assets—to begin almost immediately.

This is a matter of some importance to investors. The Fed’s security holdings affect the liquidity available to the economy and, less obviously, the plumbing of the financial markets. And as many homeowners have found to their chagrin, plumbing works silently in the background—until it doesn’t, with messy and even catastrophic aftereffects.

As the central bank’s balance sheet has shrunk, from a peak of nearly $9 trillion in April 2022 to $6.6 trillion in the week ended this past Wednesday, the volume of bank reserves has also declined (see chart below). Not to get too deeply into money-market mechanics, reserves have fallen to the point where some short-term borrowers recently have had to pay up. Specifically, the SOFR (secured overnight financing rate) has recently topped the Fed’s IORB (interest rate on reserve balances), an indication that reserves have grown less ample.

Created with Highcharts 9.0.1Dwindling ReservesAs the Fed has reduced its balance sheet, banks’ reserves also have fallen, according to​monthly data through August. The latest weekly numbers though Oct. 22 show a​further drop below $3 trillion.Reserves of depository institutionsSource: St. Louis FRED

Created with Highcharts 9.0.12021'22'23'24'252.502.753.003.253.503.754.004.25$4.50 trillion

To be sure, that is nothing like the “repocalypse” of September 2019, when the cost of repurchase agreements—borrowings collateralized by Treasury securities—temporarily soared to 9%. The top of the fed-funds target range was then 2.25%, but the Fed was also near the end of winding down its balance sheet, that is, QT.

Preventing any similar disruption in funding markets is likely to be a priority for the Fed now, says James Bianco, the eponymous founder of Bianco Research. After that misstep and the Fed’s epic fail about “transitory inflation” earlier in this decade, Powell & Co. are apt to be especially careful to avoid unnecessary market disturbance with pressure put on it by the Trump administration, he said on a client webcast on Thursday.

Other financial-market indicators pointing in the opposite direction also argue in favor of ending QT. The bankruptcies of First Brands and Tricolor are sure to elicit questions at Powell’s presser about emerging cracks in credit. The cockroaches become more visible when liquidity dries up, Bianco pithily observed, alluding to JPMorgan Chase CEO Jamie Dimon’s description of the possible spread of credit losses.

Tightening liquidity also threatens the equity market’s advance, says Steven Blitz, managing director for global macro and strategy at TS Lombard. “Given how equities are the linchpin keeping this economy afloat, the Fed is not going to let macro arguments get in the way of supporting stocks,” he wrote in a client note on Friday.

Similarly, major stock averages’ continuous march to records is “testament to the view that the S&P 500 has become completely disconnected from the real economy,” David Rosenberg, of Rosenberg Research, wrote this past week. He has prepared an artificial-intelligence-driven analysis of the Fed’s Beige Book (the compendium of reports prepared for the FOMC), to fill the gap created by the absence of official data during the government shutdown.

Rosenberg finds just 18% of the U.S. in expansion mode, down from 43% six weeks earlier. That’s the lowest percentage since May 2020; prior to the pandemic, you would have to go back to July 2009, during the recession that followed the financial crisis, to find such a depressed reading.

Inflation, meanwhile, remains sticky, even after a slightly lower-than-expected increase in the consumer price index reported on Friday during the ongoing shuttering of the government. Overall CPI was up 0.3% in September while the core measure (excluding food and energy) was up 0.2% for the month, which was helped by a smaller-than-expected 0.1% increase in so-called owners’ equivalent rent. On a year-over-year basis, both measures were up 3%.

Parsing the pieces of the report, John Ryding, Brean Capital’s chief economic adviser, points to tariff pressures pushing up apparel and footwear and household equipment prices. Away from trade, service prices excluding housing continue to be “troubling,” he added in a client note on Friday. The Fed’s so-called Supercore gauge (core services excluding housing) climbed at a 4.7% annual rate over the most recent three months.

With the Fed emphasizing softening in the labor market despite the stalled progress in reaching its 2% inflation target, quarter-point rate cuts are fully priced in for this FOMC meeting and the December confab. For 2026, the market sees two additional quarter-point reductions, to a midpoint of 2.875% by year end, under the current pace of inflation. That is also well below the end-2026 median FOMC dot plot of 3.4%, as well as those of Bank of America’s rates strategists, they write in a research note.

These market expectations should be viewed similarly to pregame betting lines, Bianco says. The Kansas City Chiefs were favored to win this year’s Super Bowl but got trounced by the Philadelphia Eagles, 40-22, he notes. Of course, the lineup at the Fed will be different next year, with Powell’s term as chair ending in May.

The Fed is likely to prevent any clogs in the plumbing of the money markets by ending QT. But financial conditions are easy. Along with record stock prices, the credit markets are booming, with a record $38 billion deal being readied for data centers tied to Oracle, Bloomberg reported. Market expectations of the Fed bringing the funds rate below inflation next year may turn out like bets on Mahomes & Co. this past February.

email: randall.forsyth@barrons.com