Key Highlights

• The 10y yield has declined with increasing Fed dovishness, but for how long?
• Powell suggested that QT will lead to an ample reserves regime in “coming months”
• We view the Fed’s stated desire for a shorter duration portfolio as mostly aspirational

View chart pack

10y yields lower on more dovish rate expectations – but will that last?

EXHIBIT #1:  DECLINE IN 10Y ALONGSIDE MORE DOVISH POLICY EXPECTATIONS

_{Source: BNY Markets, Bloomberg}

The yield on the U.S. 10y note is currently around 4%, the lowest level since late summer 2024. Not coincidentally, this was just before the Fed started to ease policy rates in September of last year. Exhibit #1 shows the recent sensitivity of the 10y to policy expectations. Lately, movements in the generic 12th month of federal funds futures correspond to changes in 10y yields. Almost the entire move lower in recent weeks in the latter series has been driven by more dovish rate expectations. 
 
Over the past year and a half, movements in the 10y yield have at times diverged from policy expectations, in particular during the months after the U.S. presidential election. We note that the 50bp cut on September 17 last year presaged a significant back-up in the 10y yield, only some of which corresponded with a more hawkish repricing of the fed funds curve after that jumbo cut. 
 
Noting that our full FOMC preview will be published next week before the meeting, we’ll briefly go on the record here to say that we firmly believe that the FOMC will deliver one quarter-point cut next week. Given the current outlook – which is challenged by a lack of data – we expect a second cut in December as well. However, we’re not convinced that the dovish Fed policy outlook will inexorably and unequivocally keep 10y yields locked down around 4%. As the chart above shows there have been periods since last September when fed policy expectations (as indicated by the 12th generic future in the chart) diverged from movements in the yield. We think it’s still possible that 10y yields will return to around 4.2% before long.

Tighter funding, ample reserves, and the eventual end of QT

EXHIBIT #2:  FUNDING MARKET TIGHTNESS PERSISTS

_{Source: BNY Markets, Bloomberg}

We have been writing about the decline in bank reserves and subsequent tightness in funding markets for a while now. See here, for example. We believe that the financial system is close to transitioning from an abundant reserve regime to a merely ample one. With reserve levels having been at or just under $3tn for four weeks now, the Treasury General Account (TGA) now at around $900bn and the reverse repurchase facility (RRP) seeing trivial take-up in recent weeks, it’s not surprising to see money market rates tighten. Furthermore, since the beginning of July, Treasury has issued around $700bn in new bills, including over $90bn in October alone. Exhibit #2 shows the upward pressure on short-term funding rates, with SOFR vs. EFFR and tri-party general collateral vs. IORB both inching higher and frequently printing positive. 
 
In a recent speech, Fed Chair Powell added to the discussion on funding markets and quantitative tightening. Noting that “some signs have begun to emerge that liquidity conditions are gradually tightening,” Powell suggested that balance sheet runoff could occur “in coming months.” This is consistent with our long-held belief that the Fed’s balance sheet shrinkage is due to be terminated before year end, possibly as soon as next week’s FOMC meeting. If it doesn’t occur in October, we would expect the December meeting to feature the end of QT. 
 
Between calling a halt to UST runoff and the presence of the standing repo facility, the intention is to keep funding markets in an acceptable range, even if rates tend to be tighter and more volatile than they have been since the early summer. Much of this will depend on T-bill issuance by the government, and we don’t expect the pace of new issuance to slow meaningfully for the rest of the year. 
 
Of course, ending UST runoff from the Fed’s System Open Market Account (SOMA) portfolio will still leave the Fed’s holdings at a level just above $6tn, significantly higher than the $3.5tn before the September 2019 funding market strains that led to the reversal of the Fed’s post-GFC QT process at the time. Note the increase in SOMA right after that episode, shown in Exhibit #3, as the Fed had to intervene by offering cash to the market in a special operation that last from the end of September until the onset of the pandemic, after which another round of QT ensued, taking SOMA back up to well over $8tn by the end of 2020. 

EXHIBIT #3: A LONG WAY TO GO FOR A SHORTER DURATION SOMA PORTFOLIO

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

Exhibit #3 also shows the breakdown of SOMA by T-bills (currently just under $200bn of the over $6tn portfolio), notes and bonds (over $3.5tn), MBS (just over $2tn) and TIPS (just $300bn). The Fed – via various official speeches – has expressed a preference for an all Treasury, short-duration SOMA portfolio. However, noting the paucity of bills in the portfolio and the still large weighting toward MBS, we view this desire as merely aspirational at this point. T-bills comprise nearly 17% of all public debt outstanding in the U.S. at the moment, while they are only 3.1% of SOMA. MBS comprise approximately another third of the portfolio. 
 
Powell addressed the composition of the balance sheet in high-level remarks during the same speech, saying that “the longer-run composition will be a topic of Committee discussion,” and promising that any transition would “occur gradually and predictably, giving market participants time to adjust and minimizing the risk of market disruption.” In other words, we don’t expect any significant changes soon. 

Chart pack