Powell sees signs of crisis

Powell's primary motivation for halting balance sheet reduction is to prevent a liquidity crisis in the financial markets.

Written by: Le Ming

Source: Wallstreetcn

Today, Powell suddenly announced that he is preparing to halt balance sheet reduction.

What did he see!?

Main Motivation of Powell

Powell's primary motivation for stopping balance sheet reduction is to prevent a liquidity crisis in the financial markets.

Powell mentioned in his speech:

Some signs have already begun to appear, indicating that liquidity conditions are gradually tightening, including a general strengthening of repo rates and more pronounced but temporary pressures on specific dates. The committee's plan sets out a prudent approach to avoid the kind of money market tensions seen in September 2019.

What does this mean?

Let's look at a chart to understand.

Chart: SOFR

The SOFR (Secured Overnight Financing Rate) shown above is one of the most important short-term rates globally today and is the core representative of the "repo rate" mentioned in Powell's speech. (Since 2022, the Federal Reserve has promoted SOFR to replace LIBOR; now trillions of dollars in loans, bonds, and derivatives are priced using SOFR.)

SOFR is the actual transaction rate for overnight repo transactions using U.S. Treasury securities as collateral.

Simply put, financial institutions use U.S. Treasuries as collateral to borrow cash overnight from other institutions. The average rate of this "collateralized short-term borrowing" is SOFR.

So, what is the relationship between SOFR and the Federal Reserve's policy rate FFR?

The Federal Reserve's policy rate, FFR (Federal Funds Rate), is an artificially set interest rate range. The Fed controls it through an upper and lower limit corridor: ON RRP (Overnight Reverse Repo Rate) is the lower bound, and IORB (Interest on Reserve Balances) is the upper bound.

Currently, the Fed's policy rate is 4.00%-4.25%, which means ON RRP (Overnight Reverse Repo Rate) is set at 4.00%, and IORB (Interest on Reserve Balances) is set at 4.25%.

So how does the Fed keep the policy rate within the corridor?

First, let's look at the upper bound, IORB (Interest on Reserve Balances): Banks have reserve accounts at the Fed, and the Fed pays interest on these reserves (currently 4.25%), so banks have no reason to lend money to other banks at rates below 4.25%, which forms the interest rate ceiling.

Now, the lower bound, ON RRP (Overnight Reverse Repo Rate): The full name is Overnight Reverse Repo. Although money market funds and others cannot hold reserves (reserves are exclusive to banks), they can participate in the Fed's reverse repo facility: lending cash to the Fed overnight, with the Fed providing Treasuries as collateral, earning a safe 4.00% interest.

Since I can lend to the Fed at a 4.00% annualized rate, I have no incentive to lend at a lower rate. Thus, no market rate can stay below the ON RRP rate for long.

SOFR, on the other hand, is the rate at which institutions trade with each other in the market, not with the Fed.

Theoretically, the Fed's interest rate corridor mechanism (IORB upper bound + ON RRP lower bound) should firmly "sandwich" all short-term market rates (including SOFR), because if SOFR < 4.00%, everyone goes to ON RRP; if SOFR > 4.25%, banks release large amounts of reserves from the Fed to earn more interest (since keeping it at the Fed only yields 4.25%), thereby suppressing yields.

But the problem is, if banks no longer have ample reserves, the funds parked at the Fed can't be released for arbitrage, or are simply insufficient for "arbitrage" to bring SOFR back below the IORB upper bound, then SOFR may temporarily break out of the corridor.

Understanding this mechanism, let's look at the chart again: Around September 15, SOFR briefly broke out of the corridor, surpassing the 4.5% upper bound (when the Fed's policy rate FFR was still 4.25-4.5%). This is what Powell referred to as "more pronounced but temporary pressures on specific dates."

After the rate cut, after September 29, another "peak" appeared, which also seemed very close to or even surpassed the new upper bound of 4.25% after the rate cut.

This phenomenon of market rates constantly "testing" or even breaking through the policy rate ceiling is mainly due to banks' reserves being less ample for various reasons, so when arbitrage opportunities arise, there are no excess reserves to draw upon.

This situation occurred once in 2019:

At that time, between 2017 and 2019, the Fed was conducting the previous round of balance sheet reduction (QT), resulting in the banking system's reserve balances dropping from about 2.8 trillion USD to around 1.3 trillion USD; at the same time, the U.S. Treasury increased debt issuance, absorbing large amounts of market cash; coupled with quarter-end corporate tax payments, Treasury settlement dates, and other overlapping events, short-term market cash was instantly drained.

At that time, the banking system's liquidity "seemed abundant," but was actually pressed to the safety margin.

On September 16, 2019 (Monday), multiple events coincided: companies paid quarterly taxes (corporates withdrew cash from bank accounts → reducing bank reserves); the Treasury settled a large amount of new debt issuance (investors paid the Treasury → further reducing bank reserves). As a result, the banking system's reserves suddenly dropped by about 100 billions USD.

That day, SOFR (Secured Overnight Financing Rate) jumped from 2.2% to 5.25%; the overnight repo rate soared from about 2% to over 10% overnight; banks and brokers couldn't borrow cash, repo transactions nearly froze, resulting in a classic "liquidity stampede."

This is what Powell referred to in his speech:

The committee's plan sets out a prudent approach to avoid the kind of money market tensions seen in September 2019.

At that time, the Fed basically worked overtime overnight to deal with the crisis. On the morning of September 17, the New York Fed urgently intervened: restarting overnight repo operations, injecting 53 billions USD in cash that day to ease repo market liquidity, and continued to inject liquidity in the following days, with a total scale exceeding 70 billions USD per day, while urgently announcing a temporary halt to balance sheet reduction and starting expansion.

Obviously, Powell does not want to repeat this nightmare. The Fed's long-term plan is to halt balance sheet reduction when bank reserves are "slightly above" what is considered "adequate."

Powell judged that "we may be approaching this level in the coming months."

This means that from an operational perspective, balance sheet reduction is already close to its intended target, and continuing further may lead to excessive reserve scarcity, triggering systemic risk.

Secondary Motivation

In addition to the main motivation above, Powell also emphasized in his speech: "The downside risk to employment seems to have increased," and described the labor market as "lacking vitality and somewhat sluggish."

This also brought some comfort to the market: although halting balance sheet reduction is not a direct rate cut or stimulus policy, it removes a factor that continuously tightens financial conditions. When the economy (especially the job market) shows signs of weakness, continuing to tighten policy would increase the risk of recession.

Therefore, stopping balance sheet reduction is a preventive and more neutral policy stance shift, aimed at providing a more stable financial environment for the economy and avoiding "collateral damage" from excessive policy tightening.

Finally, Powell also mentioned:

Our thinking has been inspired by some recent events, in which signals about balance sheet reduction have triggered significant tightening of financial conditions. We are thinking of the events of December 2018 and the "taper tantrum" of 2013.

At that time, merely signaling a reduction in asset purchases triggered violent turmoil in global financial markets, indicating that the Fed is now extremely cautious in its market communication regarding balance sheet operations.

So now, releasing the signal "to halt balance sheet reduction in the coming months" in advance allows market participants ample time to digest this information and adjust their portfolios.

This clear and predictable communication approach is intended to smoothly complete the transition from tightening to neutral, avoiding unnecessary market volatility caused by sudden policy shifts. This in itself is an important means of managing market expectations.