Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Unwinding of the Fed Balance Sheet and Reserve Scarcity
Transcript
- Lucas: So the S&P 500 is down about 0.8 percent over the past five days, the Nasdaq off 1.4 percent, and the two-year Treasury yield has fallen to 3.71 percent — that's down about half a percent over the same stretch. A lot of the conversation right now is about tariffs, China growth slowing, and the World Cup boost fading. But there is something else going on beneath the surface that could matter just as much for the next few months. Luna: You're talking about the Fed's balance sheet. The one that everyone stopped paying attention to after 2020. Lucas: Exactly. Quantitative tightening — QT — has been running in the background since mid-2022. The Fed has been letting Treasury securities and mortgage-backed securities roll off its balance sheet, up to a cap of $60 billion in Treasuries and $35 billion in MBS per month. But the total is now down to about $7.2 trillion from a peak of nearly $9 trillion. Luna: Right, but the effective fed funds rate is still right at 3.63 percent, and interest on reserve balances is 3.65 percent. That gap is only two basis points. Doesn't that suggest reserves are still abundant? Lucas: It does — for now. But the gap used to be wider. In early 2023, the fed funds rate traded about 5 to 10 basis points below IOER. As reserves drain, the funds rate tends to push up toward IOER and sometimes above it. That two-basis-point spread is actually a signal that the system is getting tighter. Luna: So we're approaching the point where reserves become scarce — like what happened in September 2019. Lucas: That's the canonical example. In September 2019, reserves had fallen to about $1.4 trillion, and overnight repo rates spiked to 10 percent. The Fed had to step in with repo operations and eventually started buying Treasuries again. The balance sheet then was about $3.8 trillion. Today it's $7.2 trillion, but the economy is bigger, and banks hold more deposits. The question is: where is the 'scarce' threshold now? Luna: Some Fed staff estimates put it around $3 trillion in reserves. We're at about $3.3 trillion right now, according to the latest H.4.1 data. Lucas: That's exactly the number I was looking at. The Fed's own survey of market participants suggests the comfortable level might be even higher — closer to $3.5 trillion. So we are in the zone where the next few hundred billion of runoff could start to bite. And the FOMC has already signaled it will slow the pace of QT, likely later this year. Luna: But they haven't stopped yet. And the Treasury is also issuing a lot of debt to fund the deficit. That pulls liquidity out of the system too. Lucas: Right. The combination of QT and Treasury issuance is effectively tightening financial conditions beyond what the fed funds rate alone would suggest. Some analysts call it 'stealth tightening'. And it might explain why the equity market is struggling despite the Fed being on hold. Luna: If walking through the economy with us has made something click — maybe helped you understand what QT actually does, or why that two-basis-point spread matters — we hope you'll consider supporting the show. We deliberately don't run ads on these episodes. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small gesture that makes a big difference for us. And it keeps the analysis independent. So if you've gotten value from this episode or any others, that's the place. Luna: Alright, back to the balance sheet. So how would we know when reserves actually become scarce? Is it just the fed funds rate drifting up? Lucas: That's one signal. Another is the volume of overnight reverse repo — the ON RRP facility. That facility acts as a floor for money market rates and has been draining rapidly. It was over $2 trillion in mid-2023; now it's below $300 billion. Once that reaches zero — and it could this year — the reserve drain becomes direct. Luna: So ON RRP is like a buffer. When it's gone, every dollar of QT pulls directly from reserves. Lucas: Exactly. And that's when we could see stress. The Fed is aware of this. Several FOMC members have mentioned that the plan is to slow the pace of runoff once the ON RRP is near zero. Some think the floor is $200 billion. Others think we're already there. Luna: The minutes from the June meeting — which came out last week — said 'many participants' favored maintaining the current pace but noted the need to 'monitor money market conditions closely'. That sounds like they're getting ready to taper. Lucas: Right. And if they taper, that's effectively a dovish signal — they're acknowledging that the system is getting tight. That could push long-term rates lower, which we've already seen with the 10-year at 4.54 percent, down from 4.75 percent a month ago. Luna: So the bond market is already pricing in a slower QT. That's consistent with the yield curve still being inverted — two-year at 3.71, ten-year at 4.54 — but the inversion is narrowing. Lucas: It is. The spread is now about 83 basis points, down from over 100 earlier this year. That's typical when the market expects the Fed to ease or tighten less. But the equity market hasn't fully cheered up yet, partly because slower QT still means tighter conditions than a full stop. Luna: Do you think we get a repeat of 2019? Or is the system more resilient now? Lucas: It's probably more resilient. The Fed has the standing repo facility now, which didn't exist in 2019. That's a backstop that allows banks to borrow reserves at a fixed rate — currently 3.65 percent — so a spike like 10 percent is unlikely. But the plumbing can still get creaky. We might see the fed funds rate push above IOER, and that would be a clear signal to stop QT. Luna: So the next few months are critical. If the ON RRP goes to zero and reserves start dropping quickly, the Fed will have to act. Lucas: Yes. And the market should be watching this more closely. Right now, everyone is focused on inflation and the next rate cut. But the balance sheet unwind is the quiet variable that could force the Fed's hand before any inflation data does. Luna: So what's the takeaway for someone who doesn't follow the plumbing daily? Lucas: Watch the effective fed funds rate relative to IOER. If it starts trading consistently at 3.65 or above, that means reserves are getting scarce. Also watch the ON RRP volume — when it hits zero, the next few months of QT could be bumpy. And watch the yield curve — a further narrowing of inversion might signal that the market is pricing in slower QT, which could be a tailwind for equities. Luna: And if the Fed does taper QT, that's a form of easing — without cutting rates. It would be a significant policy shift. Lucas: Exactly. And that would be the story for the second half of 2026.