Key Highlights

• As expected, the FOMC cut rates by 25bp and ended QT last week.
• We think a December cut is still likely, even with Powell being more equivocal.
• Funding pressure persists post-rate cut; TOMOs could be next.
  
  

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EXHIBIT #1:  DECLINING ODDS OF A DECEMBER RATE CUT

_{Source: BNY Markets, Bloomberg}

As expected, the Federal Open Market Committee (FOMC) cut interest rates by 25bp last week and announced the end of quantitative tightening (QT), effective Dec. 1. There was also a double dissent, with one member (Jeffrey Schmid of the Kansas City Fed) calling for no rate cut and another (Governor Stephen Miran) advocating for a 50bp reduction. The dissents didn’t completely surprise either, and we highlighted this possibility in last week’s FOMC preview (see here). What did catch the market’s attention was the pushback on a December rate move offered by Fed Chair Jerome Powell at his press conference. He characterized the possibility of a third consecutive cut as “far from” a foregone conclusion. 

EXHIBIT #2:  MUCH SHALLOWER RATE PATH AFTER LAST WEDNESDAY

_{Source: BNY Markets, Bloomberg}

This reticence on future rate reductions was echoed in appearances by Dallas Fed President Lorie Logan and Cleveland Fed President Beth Hammack later in the week, both of whom indicated that, had they been voting members of the FOMC this year, they wouldn’t have voted to cut rates last week and don’t feel compelled to back a December move either. We should note that both Logan and Hammack will be voting members of the FOMC next year. This view has seen the swaps market lower its probability of a December cut from nearly 100% going into last week’s meeting, down to around 68% today. See Exhibit #1. Pricing across the curve has shifted higher, indicating a less aggressive easing path into 2026 as well, as shown by Exhibit #2, which compares the implied rate curve from the day before last week’s FOMC versus Monday’s expectation.

It's clear that the Fed, operating with little economic data due to the government shutdown, is facing an inflection point in the economy and wrestling with how to proceed, with both goals of its dual mandate in tension. Powell himself described this uncertainty in his answer to the first question posed at the press conference: “And at a time when we have tension between our two goals, we have strong views across the Committee. And as I mentioned, there were strongly differing views today, and the takeaway from that is that we haven't made a decision about December, and we’re going to be looking at the data that we have, how that affects the outlook, and the balance of risks …”

We think that the labor market is continuing to slowly deteriorate and that even with a lack of official data, this fact will become more evident in coming weeks as alternative data become available. We are concerned, along with some members of the committee, that inflation has not been brought down to its target level, and a dovish policy designed to address a weakening labor market could risk costs on the inflation side of the Fed’s mandate. As Powell has said repeatedly, “there is no risk-free path for policy as we navigate this tension between our employment and inflation goals.” Nevertheless, we think the employment side of the mandate will continue to take precedence and expect another move lower in the policy rate on Dec. 10.

EXHIBIT #3: REPO STRAIN NOT EBBING

_{Source: BNY Markets, Federal Reserve Board of Governors}

Of more immediate import on a day-by-day basis was the Fed’s decision to end its QT program and redirect proceeds from its asset-backed securities portfolio to reinvest in T-bills, both as a means of moving towards an exclusively treasury portfolio, while reducing the weighted average maturity of those holdings close to that seen in debt held by the public. Again, the move was in line with our thinking going into the meeting and comes as pressures continue to emerge in funding markets, where financing rates are pushing well above Fed reference and administrative rates. See Exhibit #3.

EXHIBIT #4: SRF MORE FREQUENT

_{Source: BNY Markets, Federal Reserve Bank of New York}

On Monday this week, overnight SOFR printed at 4.22%, placing it some 35bp above the effective federal funds rate. Even with month-end October behind us, it appears that funding markets remain tighter than desired. Between the continued issuance of T-bills from the U.S. Treasury (net issuance has increased by nearly $200B in October alone and up over $800B since July 1), the associated build up the Treasury General Account (up to around $1T, the largest balance since 2021), and declining reserves (now down well below $3T to around $2.8T, the lowest level since the end of 2022), liquidity is strained. In Exhibit #4, we show daily usage of the Fed’s standing repo facility (SRF), set up in 2022 when QT was initiated after the pandemic. It has seen more frequent use in recent weeks, as counterparties begin to realize the economics of borrowing from the SRF outweigh the stigma of using it when funding rates gap, as they have recently. Just on Monday this week, the SRF was tapped for a total of $22B, $14.75B in the morning operation and an additional $7.25B in the afternoon one. See Exhibit #4.

We don’t think that temporary open market operations (TOMOs) would be out of the question if this funding market stress continues, with rates grinding higher over the relevant Federal Reserve rates. As Logan herself put it in her appearance last Friday, “If the recent rise in repo rates turns out not to be temporary, the Fed in my view would need to begin buying assets to keep reserves from falling further and maintain an ample supply of reserves.”

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