Growing Expectations for the End of QT

As Wall Street's expectations that the Federal Reserve (the Fed) will soon end its balance sheet reduction program rapidly increase, some analysts even predict that the Fed may re-launch balance sheet expansion in a short period of time.

Many economists have called on the Fed to announce the end of quantitative tightening (QT) at the conclusion of its two-day policy meeting. The market also widely expects that the Federal Open Market Committee (FOMC), the policy-making body of the world's largest central bank, will cut the benchmark interest rate by 25 basis points to a range of 3.75%-4.00% at this meeting.

Reasons for Calling for the End of QT

Unexpected and sometimes sharp spikes in money market rates (including the federal funds rate, the Fed's policy interest rate) are the core reason analysts are calling for the central bank to end QT. In addition, the moderate and routine use of the Fed's Standing Repo Facility further indicates that the previously abundant money market liquidity is gradually tightening, which has also fueled this expected shift.

Money Market Pressures Escalated During QT Period

These indicators together show that the funds the Fed has withdrawn from the financial system through QT have reached a critical point. Many economists now believe that the QT window has officially closed if policymakers hope to continue to firmly control the federal funds rate (their core tool that influences the economy).

"Given the dynamics of the money market and the desire of Fed officials to smoothly advance this round of balance sheet management, we currently expect the FOMC to announce the end of QT next week," said Deutsche Bank strategists.

Derek Tang, co-founder of economic and research firm LH Meyer, believes: "Although it cannot be determined whether they will end QT at this meeting, I would not be surprised if they really announced it."

Mixed Signals from Fed Officials

Fed officials' guidance on the outlook for QT has been relatively brief. Fed Chairman Jerome Powell recently mentioned in a speech that QT may end in the coming months, while emphasizing the need to maintain "flexibility" in balance sheet management. Other officials, including Dallas Fed President Lori Logan, have pointed out that market liquidity is still relatively abundant; while Fed Vice Chair for Supervision Michael Barr has argued for increasing the pace of balance sheet reduction.

Standard Chartered economists said that given Barr's bias towards the balance sheet, ending the QT plan could trigger her dissenting vote.

Temporary Market Interventions and the Possibility of Early Expansion

During the Covid-19 pandemic, the Fed stimulated the economy by purchasing large amounts of U.S. Treasury bonds and mortgage-backed securities (MBS), which more than doubled the size of its balance sheet; the balance sheet reduction process that followed reduced asset holdings from a peak of about $9 trillion in 2022 to $6.6 trillion currently. The Fed mainly achieves balance sheet reduction by allowing Treasury bonds and MBS to reach their maturity dates naturally, but housing market problems have caused balance sheet reduction pressures to be mainly concentrated on Treasury bonds.

The Fed aims to allow the financial system to retain sufficient cash by withdrawing excess liquidity to ensure that the federal funds rate remains at the level policymakers want, while allowing for normal fluctuations in the money market. But the problem is that there are no clear indicators that can predict when these goals will be achieved. In the last round of QT, the Fed inadvertently over-reduced the balance sheet in September 2019, ultimately forcing it to re-launch market injection operations.

Fed officials had hoped that the Standing Repo Facility (which can quickly convert bonds into cash) would act as a "buffer" to deal with potential liquidity problems, thereby providing more room for QT. In addition, officials retained the right to manage liquidity through traditional open market operations (temporarily or permanently buying bonds).

There are still variables in the latest expectations for QT: some forecasters believe that the Fed may need to re-launch financial system injections. Some analysts have pointed out that the current pace of QT is close to a standstill, and even if the termination is announced this week or soon, it may not achieve the effect needed to stabilize the money market.

JPMorgan analysts told clients that after ending QT this week, Fed officials should take temporary market intervention measures "immediately", while lowering the lending rate for the Standing Repo Facility and increasing the attractiveness of using the tool.

The investment bank further pointed out that in order to maintain money market stability, the Fed should start buying bonds in the first quarter of 2026, re-launching balance sheet expansion.

Evercore ISI agrees with this judgment, stating in its report: "We believe that the Fed will shift to net bond purchases sooner than it plans or what is agreed upon in the market to meet the natural growth needs (of the balance sheet), and we expect it to begin sometime in the first quarter of next year, with net purchases of about $35 billion in Treasury bonds per month."

Given the challenges the Fed faces in reducing MBS, most views are that the balance sheet reduction process for Treasury bonds will continue to reach maturity dates naturally, meaning that Treasury bonds will become the core of balance sheet management. Deutsche Bank expects that the Fed's future bond purchases (which it also expects to start at the beginning of next year) will mainly focus on short-term Treasury bills.

However, some analysts have presented unconventional views: if the Fed takes temporary market intervention measures, QT may even be extended.

Bill Nelson, a former Fed official and current chief economist at the lobbying group "Bank Policy Institute," said: "If occasional temporary open market operations are used to supplement reserves, the Fed will eventually be able to reduce the size of the balance sheet to a level far lower than can be achieved by simply allowing reserve balances to fluctuate." He pointed out that Friday's Treasury bond auction settlement will put significant pressure on market liquidity, "This will be a good time to start (temporary intervention)."