iFlow > Short Thoughts
Published on Tuesdays, Short Thoughts offers perspectives on US funding markets, short-term Treasuries, bank reserves and deposits, and the Federal Reserve's policy and facilities.
John Velis
Time to Read: 4 minutes
EXHIBIT #1: RATE PATH NOW SHALLOWER THAN BEFORE OCTOBER FOMC
Source: BNY Markets, Bloomberg
The FOMC meets on Wednesday, and market expectations currently imply a 93% chance of an interest rate cut. We don’t disagree with that pricing. But there are a few other things to watch at this gathering, including how widely supported the anticipated rate move will be across the Committee – will there be dissents as there were at the October FOMC? A new set of dots will be published as part of the quarterly Summary of Economic Projections (SEP). Finally, we may very well get an announcement that the Fed is ready to step in and provide liquidity support to fund markets at year end and into 2026.
Implied interest rates through the end of next year are shown in Exhibit #1. While the expected policy path is less aggressive now than it was before the previous FOMC in October, it still shows nearly 75bp in cuts between now and next December. From where we sit, these expectations seem reasonable, although we confess to possessing low conviction for 2026. The U.S. macroeconomy is clearly at an inflection point, yet the outlook is still obscured due to the lack of data, and the Fed is in danger of missing on both objectives of the dual mandate. In such an environment, it’s difficult to be too precise on policy developments over the next 12 months, especially considering upcoming personnel changes at the Board of Governors.
The post-meeting press conference could be – as always – a wild card. During recent FOMC pressers, Chair Powell’s tone has often departed from the actual policy action taken or the statement accompanying that action. We could easily see a rate cut, a dovish set of dots, and a somewhat hawkish qualitative assessment at Wednesday’s press conference. Last month’s admonishment that a December rate cut was “far from” a foregone conclusion, even after cutting rates at the meeting itself, serves as a good example. We expect the Chair to remind his audience that the dots in the SEP are not a forecast or a plan, and to stress data dependence in making future decisions, especially considering we will finally get impactful government-produced economic readouts starting next week.
The labor market is weakening, and we’re therefore on the side of the various dovish Fedspeakers who have communicated their views to the market. However, we’re less sanguine about inflation, something often dismissed by those same doves who claim that tariff inflation is nothing to worry about. We think inflation is at risk of getting stuck near – or even above – 3% into next year, and ultimately something that the Fed will have to address. This has been the hawkish argument all along in favor of keeping rates steady – that inflation is the primary concern. Of course, for their part, the hawks have been generally unconcerned about job market dynamics, something we think will change once the data start to reflect labor weakness in a more pronounced manner. This dilemma – sticky inflation versus a vulnerable labor market – is precisely why Chair Powell has asserted that there is “no risk-free path for policy.”
EXHIBIT #2: FUNDING PRESSURES GOING INTO YEAR-END
Source: BNY Markets, Federal Reserve Board of Governors, Federal Reserve Bank of New York, Bloomberg
To us, the rate decision is relatively straightforward, even if the commentary around it could take on multiple, nuanced implications. Just as interesting – and crucial – will be whether the Fed announces term repo operations or a new policy of open market operations going into the end of the year and beyond.
Quantitative tightening (QT) formally ended just a week ago, on December 1, in response to tightening liquidity conditions in funding markets. Reserves began to fall this past summer, the result of heavy T-bill issuance after the signing of the Republican budget plan in early July. Between July 1 and November 30, Treasury sold $939bn in bills. Through the end of October, total issuance since July 1 amounted to just over $800bn, and money market mutual funds picked up over $600bn of that – a remarkable asset allocation shift for MMFs. We are still awaiting final money fund data for November, but we expect it to reveal that a similar proportion of short-term Treasury paper was purchased by the market.
This has led to a drain of reserves, something we have been commenting on over the past several weeks (see here and here), ultimately leading to the FOMC announcing the termination of QT at its October meeting, as we expected. At that meeting, the New York Fed’s money markets desk argued that “further reductions in the size of the portfolio may prove short-lived because they would bring forward the time when the Desk would need to restart purchases of securities to maintain ample reserves.” In other words, as we approach critical funding dates (like month-, quarter-, and year-end), the Fed may need to step in and provide liquidity support and find itself regrowing the balance sheet.
Admittedly, we have wavered on this question. Last week, we wrote that we were unconvinced that such an announcement would be forthcoming, given the lack of public commentary from relevant Fedspeakers. However, we have changed our view based in part on those comments in the minutes, as well as based on where we see funding markets at year end. We expect term repo operations to be offered over the year-end turn, and possibly the creation of a TOMO-like facility to support money markets as reserves stay under pressure.
The need to maintain ample reserves (rather to let them slip into a scarce state, in which rate control would be severely compromised) is important. An ample reserve regime is defined as one in which changes in reserves (say, lower) lead to upward movements across the constellation of front-end interest rates. As Exhibit #2 shows, funding spreads have been on the rise since the end of August, corresponding to the concurrent decline in reserves. The chart also shows a pronounced rise in funding rates at the end of 2024, a period that most observers would describe as featuring abundant reserves. If reserves are now merely ample, then funding pressures at the end of this year could be even more acute than last year. Hence the need for vigilance and preparedness going forward.
The September SEP indicated a 3.4% median fed funds rate for the end of 2026. That’s likely to change once the new dots are released on Wednesday. We wouldn’t be surprised to see a median projection closer to the current market expectations of around 3.0%. Again, Chair Powell’s comments in his press conference will provide critical context around the dots. With the labor and inflation backdrop still uncertain for next year, we stick with two rate cuts in 2026 in addition to the rate move this week.
