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The Federal Reserve's Approach to Rate Cuts and Balancing Financial Markets

James L. Flint

• January 08, 2024

Investors closely monitoring the prospects of rate cuts in 2024 can also expect the Federal Reserve (Fed) to support financial markets through another crucial measure. BofA Global's rates team, headed by Mark Cabana, now predicts that the Fed will begin reducing rates from a 22-year high in March. Additionally, they anticipate the Fed unveiling plans to halt the reduction of its approximately $7.7 trillion balance sheet by midyear.

As a response to the pandemic fallout, the Fed reintroduced a crisis-era program in early 2020. This program empowers the central bank to purchase trillions of dollars worth of U.S. Treasurys and government-backed mortgage bonds. While this approach helps contain economic challenges, it has been criticized for potentially incentivizing excessive risk-taking and creating asset bubbles that endanger financial stability.

Cabana's team stated in a client note on Monday, "At the March FOMC meeting, when we think the Fed initiates its first 25bp rate reduction, we expect the Fed to announce the tapering of runoff for its holdings of Treasury securities." This indicates that members of the Fed Open Market Committee possess the ability to adjust short-term interest rates and manage the size of the Fed's balance sheet. By shrinking or expanding the portfolio, they can promote smooth market functioning or tighten financial conditions during times of stress.

During a speech in Dallas, Dallas Fed President Lorie Logan emphasized the benefits of "normalizing" the Fed's balance sheet at a gradual pace. This approach helps in smoothing redistribution and reduces the risk of premature cessation. It is worth noting that the Fed has played a pivotal role as an anchor investor in both the roughly $26 trillion Treasury market and the $12 trillion agency mortgage-backed securities market.

Logan further stated that the reduction of the Fed's balance sheet should slow down when overnight reverse repo balances reach a low level. Cabana's team estimates that this "low level" could amount to $200 billion to $250 billion. As of Friday, the demand for the program declined to under $700 billion, a significant drop from the peak of approximately $2.5 trillion during the pandemic.

A Shift in Liquidity: Excess Funds Depart From Overnight Reverse Repo Facility

As the year unfolds, it appears that a growing amount of liquidity is being diverted away from the overnight reverse repo facility. With stocks facing a challenging start to 2024, the Dow Jones Industrial Average (DJIA) has recently chalked up a series of record closes. Similarly, the S&P 500 index (SPX) finished last week a mere 2% below its all-time high, as reported by Dow Jones Market Data.

In tandem with these developments, the benchmark 10-year Treasury yield (BX:TMUBMUSD10Y) has remained below 4% since the beginning of the year. This comes as a welcome reprieve, following its spike to 5% in October, which wreaked havoc in financial markets.

After reaching a peak of 9.1% in July 2022, inflation prompted the Federal Reserve to take action by reducing its balance sheet and raising interest rates. While inflation has since receded, it still hovers above the Fed's target of 2%. As investors await the latest inflation figures for December, set to be released on Thursday, it remains a key focal point.

To shrink its balance sheet, the Fed has been allowing up to $60 billion in Treasurys and up to $35 billion in agency mortgage-backed securities (MBS) to mature and roll off its balance sheet each month. However, due to high mortgage rates, the monthly caps for MBS haven't been reached.

The Bank of America (BofA) team foresees the Fed tapering Treasury roll-offs, commencing in March and concluding in July. On the other hand, they expect the MBS program to remain unchanged.

Moreover, the team predicts that the Fed will implement 100 basis points of rate cuts throughout the year, bringing the U.S. central bank's short-term policy rate to 4%. Subsequently, they anticipate it dropping further to around 3% by early 2026.

"BofA's outlook for monetary policy also includes an end to quantitate tightening (QT) by midyear," wrote the Cabana team.

Quantitative easing (QE), the term used when a central bank buys bonds to expand its balance sheet, was first utilized in the aftermath of the 2007-2008 global financial crisis as a means of rapidly injecting liquidity into markets. Conversely, quantitative tightening (QT) refers to the process of shrinking a central bank's balance sheet.