Market warning signals are frequent! The Federal Reserve's balance sheet reduction "emergency brake" is imminent.

When Federal Reserve policymakers meet next week to decide whether to cut interest rates again, they will also face another increasingly urgent issue - when to stop shrinking the central bank's $6.6 trillion securities portfolio. Due to the potential exacerbation of liquidity constraints and market turmoil by quantitative tightening (QT), the Fed had earlier this year slowed the pace of reducing monthly bond holdings. However, in recent weeks, the money market has sent out more warning signals, indicating that the quantitative tightening process may have reached its limit. The latest signal is that the U.S. banking system's reserve balances fell below the $3 trillion mark this week for the second week in a row. The level of reserve balances in the U.S. banking system is a key factor in the Fed's decision on whether to continue shrinking its balance sheet. Data shows that for the week ending October 22, reserve balances at banks fell by approximately $59 billion to $2.93 trillion, marking the lowest level since the week of January 1. Since the Fed began reducing its balance sheet in June 2022, over $2 trillion has flowed out of the financial system. This has nearly exhausted the main liquidity indicator - the reverse repurchase agreement (RRP) tool. At the same time, the issuance of a large amount of short-term debt is attracting more cash flow into the market. As a result, various interest rates used for interbank borrowing have been rising, and tools set up to alleviate market pressure have been frequently used in the past week. Even the Fed's benchmark rate - usually seen as less sensitive to liquidity conditions - rose within its target range for the first time in two years. In this context, Fed Chair Powell is almost certain to discuss the future direction of the central bank's balance sheet at the meeting on October 28-29. In a speech two weeks ago, he already indicated for the first time that the process of shrinking the balance sheet may end in the coming months. For many Wall Street professionals, if the Fed wants to avoid a repeat of the severe market turmoil in September 2019, they must act swiftly. At that time, the Fed's further tightening of the balance sheet caused short-term interest rates to surge, threatening its control over financing costs and the overall economy. Mark Cabana, head of U.S. interest rate strategy at Bank of America, said: "You can fully understand that the Fed not only faces risks - they have actually entered the 'middle ground.' This somewhat echoes what happened in 2019, the Fed may have excessively withdrawn liquidity from the system, and they are well aware of this." Bank of America and JPMorgan Chase joined the ranks of Deutsche Bank and Wrightson ICAP this week in anticipating that the Fed would end quantitative tightening at the October meeting. Several other institutions have also brought forward their predictions for the end time to December of this year from early next year. Jason Granet, chief investment officer at Mellon Bank of New York, said that since Powell's speech, the balance sheet issue has been brought to the forefront. He warned that if the Fed delays further, the situation may deteriorate by the end of the year. He said, "They have seen the signs and are prepared to take action. In this case, I think they will choose a relatively cautious stance." The Fed decided in April to slow down the pace of balance sheet reduction to prevent potential disruptions caused by the U.S. government raising the debt ceiling in the summer. Since July, the U.S. Treasury has issued a large amount of short-term Treasury bonds to rebuild cash reserves, drawing away reserves at banks held at the Fed. The Fed has long stated that once reserve balances fall to a so-called "sufficient" level - the minimum required to prevent market disruptions - it will stop shrinking the balance sheet. Fed Governor Christopher Waller previously estimated the "sufficient" level to be around $2.7 trillion, but recently hinted that reserves may have already approached that lower limit. U.S. bank strategists pointed out that the current or higher money market rates should signal to the Fed that reserves are no longer "abundant." Based on some indicators, the Fed may also consider that reserves are no longer "sufficient." If the Fed were to end its balance sheet reduction early, it could repurchase securities to replenish reserves. JPMorgan Chase strategists expect that once quantitative tightening ends, the Fed will immediately launch temporary open market operations to ease financing pressures around settlement dates, and begin regularly purchasing short-term Treasury bonds for reserve management starting in early 2026. Short-term interest rates have remained stubbornly high recently, even outside of key settlement periods such as Treasury auctions or tax payments. In the past month, the Effective Federal Funds Rate (EFFR) - a rate that usually sees little fluctuation during Fed meeting intervals - has risen within the target range three times. Matthew Raskin, head of U.S. interest rate strategy at Deutsche Bank, pointed out that compared to 2018, it took months for the benchmark rate to rise to such levels. Mark Cabana said that based on where the Fed sees short-term rates relative to the interest on reserve balances (IORB), the central bank may need to "recoup" about $150 billion in liquidity. Dallas Fed President Lorie Logan stated in August that the Fed is watching to see if market rates stabilize near or slightly below the level of the IORB. While there may be differing views within the Fed on the ideal level of reserves, patience seems to be running out after some rates have risen above the IORB. JPMorgan Chase strategists pointed out that the market turmoil in September 2019 showed that the Fed has limited tolerance for volatility in the federal funds rate and the "money market fund system." The team said, "If they make the same mistake again, the consequences could be very serious."