Key Highlights

• Ample reserves and a shrinking balance sheet require open market operations to tamp down on funding volatility.
• Balance sheet size, RMPs and funding rates comprise three elements of the balance sheet “trilemma.”
• MMFs will likely increase T-bill holdings in the face of increased supply, potentially leading to less cash in repo. 

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RMPs, a shrinking TGA and growing reserves lead to funding market stability

EXHIBIT #1: REPO RATES BEHAVE WELL IN JANUARY

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

EXHIBIT #2: LOWER TGA AND HIGHER RESERVES HELP MAINTAIN AMPLE LIQUIDITY 

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

Last week, the Federal Reserve Bank of New York announced that it would undertake another $40bn in reserve management purchases (RMPs) this month, intended to shore up liquidity in the money markets. January’s RMPs follow equally sized purchases last month. The Fed will also add some $15bn in T-bill purchases this month, in accordance with its intention to reinvest agency security principal payments.

Last Wednesday, the Treasury general account (TGA) declined to around $777bn, one of the lowest levels so far this year and well below the $1tn observed at the end of October. Declines in so-called non-reserve liabilities like this tend to stabilize funding rates, as they are offset by increases in reserves that add liquidity to the market. Exhibit #1 shows recent developments in the three main liabilities on the Fed’s balance sheet. Note that reserves – thanks to a combination of a falling TGA and RMPs – ticked up slightly.

So far this month, money market rate volatility – and levels – have retreated to more stable territory after a year-end period that exhibited – not unexpectedly – higher and more volatile funding spreads (see Exhibit #2). The December RMPs and appreciable usage of the Fed’s Standing Repo (SRP – formerly SRF) appear to have served their purpose.

Understanding the balance sheet trilemma

This combination of developments in reserves, RMPs, the TGA, and funding rates illustrates the workings of a relatively closed market system. A recent paper from the Fed Board of Governors refers to this system as a “trilemma.” A smaller central bank balance sheet (related to the quantity of reserves) means the monetary authority must either tolerate rate volatility and elevated spreads or engage in open market operations – such as the recent RMPs – to stabilize them.

Think of a triangle with a small balance sheet at one vertex, open market operations at another, and stable funding conditions at the third. A central bank can achieve one of these conditions, but not without relaxing one of the other two. In other words, a central bank can maintain a small balance sheet, but when reserves are merely ample – or even scarce – rather than abundant, it cannot avoid open market operations if it wants to keep funding rates – and ultimately policy rates – under control. If the central bank undertakes open market operations, the balance sheet increases with reserves, achieving money market stability. If the central bank wants stable rates, the balance sheet cannot shrink too much or too fast without resorting to open market operations.

This is reflected in the current setup. Reserves fell below $3tn in early October last year and rose back above that figure this past week. This was due in part to the aforementioned decline in the TGA and in part to RMPs. In any case, to avoid more volatile funding conditions at the end of December, the balance sheet expanded. Again, a central bank can fulfill two of the elements of the triangle, but not all three simultaneously. Hence the trilemma. 

Money funds boost bill allocations, likely to buy more as issuance picks up

EXHIBIT #3: MMF ALLOCATIONS SHIFT BACK INTO T-BILLS

_{Source: BNY Markets, Crane Data}

Last week, we discussed the expected ramp up in T-bill issuance, with upside risks stemming from a potentially unfavorable outcome (for the administration) in the current IEEPA tariffs case, which is expected imminently, as well as the possibility of increased fiscal spending in 2026. Any significant increase in bill supply would have to find demand in the market. We can pencil in approximately $320bn in RMPs from the Fed this year – $40bn per month through April, tapering to an assumed $20bn per month thereafter.

Any additional supply would have to find a home in the market. One obvious source of demand is money market mutual funds (MMFs), which have been increasing their Treasury allocations since last summer. Exhibit #3 shows the main components of MMFs’ portfolios: USTs, repo and other assets.

After falling to just 35.5% of aggregate MMF portfolios in June 2025 – compared with 42.2% in repo – T-bill allocations ramped up to nearly 45% by December, while repo fell to 36.7%. The midyear low in bill allocations was a result of negative bill supply in Q2 2025 – net issuance fell by nearly $500bn – while the debt ceiling was in force. Subsequent bill supply – an increase in net issuance of nearly $940bn through the end of November – allowed MMFs to redeploy their growing assets back into bills.

Looking further back, massive bill issuance and a concurrent increase in the TGA to well over $1.5tn during the COVID pandemic prompted equally large MMF purchases. The fund complex’s holdings of USTs from 2020 through early 2021 exceeded 50% of total assets. While bill issuance in 2026 is unlikely to approach 2020–2021 levels, the increase in supply will likely be met by MMF purchases. Relatedly low MMF allocations to repo during that period were mitigated by growth in the Fed’s balance sheet and reserves.

That implies a lower allocation to repo, potentially squeezing funding markets. Back to the trilemma, we expect that more bills likely mean lower reserves (and a higher TGA), requiring continued Fed interventions in the open market to avoid renewed rate volatility. It’s useful to look at this nexus of balance sheet size, open market operations, and rate volatility this way. Adding the expected increase T-bill demand from MMFs helps illustrate how the three elements of the trilemma triangle interact.

Rates outlook

As we enter the final week before the next FOMC meeting, we note meaningful shifts in the OIS curve, which has turned less dovish. A generally strong week of data, along with backlash against the Department of Justice’s probe of the Fed – which ironically may have enhanced the Fed’s independence, at least in the short term – has pulled back rate cut expectations. The market currently sees only 44bp of cuts by December 2026, down from over two full cuts expected at the turn of the year. We maintain our rather out-of-consensus forecast of three cuts, most likely starting in June.

We are more dovish than the market – and many of our peers on the Street – because we remain concerned the labor market remains at risk. Jobs created, as reported by the establishment survey, rose just 0.4% in the 12 months through December 2025. Since the end of World War II, this 12-month growth rate has been seen only once outside of a recession – back in early 1952. We need to see more – and at least stable, if not improving – labor data before we question our relatively dovish stance.

Inflation remains well above 2%, as last week’s CPI and PPI showed. This sets up a weaker PCE print (the Fed’s official target measure of inflation) due later this week. At this juncture, there is some optimism that tariff effects have been completely passed through the inflation channel. However, last week’s Fed Beige Book indicates that tariff-driven price increases may still emerge, as firms are running out of pre-tariff inventory and can no longer compress margins.

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