Nordea Markets analysts suggest that stress in the US repo markets since mid-September tells the Fed that the balance sheet normalisation or Quantitative Tightening (QT) has gone too far, prompting Fed Chair Jerome Powell to announce that excess reserves will be returned to near the early September level and kept there as a new normal after which the Fed's balance sheet will grow organically.

Key Quotes

“What the repo stress is telling the Fed

The Fed lost control of short-term interest rates in mid-September and thus effectively lost its ability to implement monetary policy. Temporary factors play a role, but a more structural question needs to be answered at the October FOMC meeting: What is the appropriate level of excess reserves?”

“The "new normal"

The Fed has moved from QE to QT to a constant balance sheet, but a new normal for excess reserves has not been established. Changes to the Fed's bond holdings have received much more attention than the consequent implications for liquidity, and keeping bond holdings constant is not enough to prevent liquidity shrinkage. This is important to understanding the Fed's October decisions.”

“Important decisions ahead

The Fed will address the excess reserve issue at the October FOMC meeting. We expect liquidity injections in November, after which excess reserves should be held constant and the balance sheet should grow "organically". A standing repo facility might be the best long-term solution, but the Fed will likely wait to implement it.”

“Market implications

So far, the Fed looks too reactive on USD liquidity for us to really consider this liquidity addition as a big game changer for our pretty bearish market view. The Fed may dance to another liquidity tune, however, if and when the outlook worsens more in Q1 2020.”

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