Original Author: Zhang Yaqi

Original Source: Wall Street Journal

As the Federal Reserve's interest rate meeting approaches on December 10 next week, the market is not only focused on the anticipated interest rate cut, but senior strategists on Wall Street point out that the Fed may soon announce a significant asset balance sheet expansion plan.

Recently, former New York Fed repo expert and Bank of America interest rate strategist Mark Cabana predicted that, in addition to the widely expected 25 basis point rate cut, Fed Chairman Powell will announce a plan to purchase $45 billion in Treasury bills (T-bills) monthly next Wednesday. This bond-buying operation is set to officially begin in January 2026, aimed at injecting liquidity into the system to prevent further spikes in repo market rates.

In his report, Cabana warned that while the interest rate market has reacted mildly to the rate cut, investors generally "underestimate" the Fed's actions regarding the balance sheet. He pointed out that the current levels of money market interest rates indicate that the banking system's reserves are no longer "ample," and the Fed must fill the liquidity gap by restarting bond purchases. Meanwhile, UBS's trading department has also provided a similar forecast, believing that the Fed will begin purchasing about $40 billion in Treasury bills monthly in early 2026 to maintain stability in the short-term interest rate market.

This potential policy adjustment occurs at a critical time as the Fed leadership is about to change. With Powell's term nearing its end and market expectations rising for Kevin Hassett to possibly succeed him as Fed Chairman, next week's meeting will not only concern short-term liquidity but will also set the tone for the monetary policy path for the coming year.

Former New York Fed Expert Predicts: $45 Billion Monthly Bond Purchases

Although the market consensus has locked in a 25 basis point rate cut by the Fed next week, Mark Cabana believes the real variable lies in the balance sheet policy. In his weekly report titled "Hasset-Backed Securities," he pointed out that the scale of the RMP (Repo Market Program) to be announced by the Fed could be as high as $45 billion monthly, a prediction that significantly exceeds current market expectations.

Cabana detailed the composition of this figure: the Fed needs to purchase at least $20 billion monthly to address the natural growth of its liabilities, in addition to needing to buy an extra $25 billion to reverse the previous "excessive balance sheet reduction" that led to a loss of reserves. He expects this level of bond buying to last for at least six months. This statement is expected to be included in the Fed's execution instructions, with detailed operational scale and frequency published on the New York Fed's website, focusing on the Treasury bill market.

According to a previous article from Wall Street Journal, since the balance sheet peaked at nearly $9 trillion in 2022, the Fed's quantitative tightening policy has reduced its size by about $2.4 trillion, effectively withdrawing liquidity from the financial system. However, even though QT has stopped, signs of funding stress remain evident.

The clearest signal comes from the repo market. As the short-term financing hub of the financial system, the overnight reference rates in the repo market, such as the Secured Overnight Financing Rate (SOFR) and the Tri-Party General Collateral Repo Rate (TGCR), have frequently and sharply breached the upper limit of the Fed's policy interest rate corridor in recent months. This indicates that the level of reserves within the banking system is sliding from "ample" to "adequate," with the risk of further moving towards "scarcity." Given the systemic importance of the repo market, this situation is considered difficult for the Fed to tolerate in the long term, as it may weaken the transmission efficiency of monetary policy.

In this context, recent statements from Fed officials also suggest the urgency for action. New York Fed President John Williams has stated, "We expect to reach ample reserve levels soon," while Dallas Fed President Lorie Logan has also indicated that "it is appropriate to restore balance sheet growth soon." Cabana interprets "soon" as referring to the December FOMC meeting.

A Tool Aimed at Smoothing Year-End Volatility

In addition to the long-term bond purchase plan, to address the upcoming year-end funding volatility, Bank of America expects the Fed to announce term repo operations lasting 1-2 weeks. Cabana believes that the pricing for these operations may be set at the standing repo facility (SRF) rate or 5 basis points above it, aimed at reducing tail risks in the year-end funding market.

Regarding interest rate management, although clients have inquired whether the interest on reserves (IOR) will be lowered, Cabana believes that simply lowering the IOR "does not solve any problems," as banks generally prefer to hold higher cash buffers following the collapse of Silicon Valley Bank (SVB). He thinks it is more likely that both IOR and SRF rates will be synchronized down by 5 basis points, but this is not the baseline scenario.

Another important background for this meeting is the personnel changes the Fed is about to face. The market currently views Kevin Hassett as a strong contender for the next Fed Chairman. Cabana points out that once the new chairman is confirmed, the market will price the mid-term policy path more according to the new appointee's guidance.

UBS also agrees with the view of a return to balance sheet expansion. UBS's sales and trading department noted that by purchasing Treasury bills, the Fed can shorten the duration of its assets, thereby better matching the average duration of the Treasury market. Whether this operation is called RMP or quantitative easing (QE), its ultimate goal is clear: to ensure that financial markets can maintain stable operations during critical transitions in the political and economic environment through direct liquidity injections.

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