The U.S. central bank still needs to reduce its asset holdings. The target is a $5.8 trillion balance sheet, down from the current $6.7 trillion. Also, aiming for $2.7 trillion in reserves would be better compared to the present $3.3 trillion. Adjustments to the balance sheet might be less drastic than expected. The plan includes gradually shifting more assets toward Treasury bills, which will be a slow and predictable change. This adjustment is anticipated for the future. The Federal Reserve’s losses are tied to its asset purchases rather than its overall policy. Right now, the Fed has too many long-term assets. The balance sheet grew significantly after COVID-19 to boost the economy. There is a focus on unwinding these holdings, but this should be done carefully. Current guidance suggests a steady but cautious drawdown of Federal Reserve assets. The pace of reduction is not as urgent as previously thought. Instead, there is a preference for predictability to avoid sudden changes in key funding markets. Treasury bills, which mature quickly and have low interest-rate risk, are seen as safer options for reinvestment. This shift impacts the central bank’s portfolio structure as well as liquidity, short-term yields, and market expectations. Chair Jerome Powell and his team seem to prioritize market stability over hastily cutting the balance sheet. Rather than aggressively removing support, they are allowing it to decrease naturally, letting market conditions adjust gradually. The target of $5.8 trillion shows that the process is still ongoing, just more measured. With reserves, the decrease from $3.3 trillion to $2.7 trillion invites a re-evaluation of what constitutes comfortable liquidity. The Reverse Repo Facility has indicated that banks and funds are willing to hold cash when safe options are limited. As this facility gradually reduces, reserves may drop quickly, but the target range serves as a lower limit that policymakers are unlikely to breach lightly. Understanding current losses is crucial. They mainly stem from a large amount of long-term assets bought when yields were low. As rates rose, the income from these assets no longer covered the interest paid on reserves and reverse repos. This mismatch is now factored into future expectations. The bond curve, especially for 3 to 5-year bonds, is very sensitive to messages from policymakers. For those watching derivatives, this means any unexpected hawkish signals could significantly reprice this segment—more than at either end of the curve. Calendar spreads and longer-term trades may be less attractive unless supported by data. Although balance sheet reduction is slow, it supports front-end borrowing rates and puts slight upward pressure on term premiums. In the short term, we might expect yields to stay within a range, but with less compression. The consistency of the policy rate path faces some subtle upward nudges. Favoring Treasury bills over longer bonds will likely lead to more frequent auctions in the short-maturity sector. This creates chances for auction congestion and potential mismatches. Funding trades that benefit from occasional spikes in short-term repo rates may thrive in an environment where collateral supply increases while balances decrease. Each change will impact futures, swaps, and volatility. Recent minutes indicate an interest in maintaining flexibility rather than tight restrictions. This means that medium-term curve steepeners or strategies that benefit from risk premiums in the midcurve area may have better reward-to-risk profiles. In the coming weeks, it will be important to closely watch any changes in the pace of asset runoff and signals for Treasury bill reinvestment. Keeping an eye on liquidity in FX swap markets or comparing T-bill yields to Fed reverse repo rates could provide early insights. As always, anticipating policy surprises in futures before they happen is more profitable than reacting after they occur.

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