A standoff over the U.S. government debt limit could amplify the Federal Reserve’s quantitative tightening process later this year, Bloomberg reported Tuesday, citing interviews with economists and strategists.

The U.S. Treasury’s actions to stave off default on U.S. government debt while Congress locks horns on whether to raise, the $31.38T debt limit, suspend it, or cut spending could spell an early end to the Fed’s QT, they said. The government reached the limit on Thursday, and the Treasury started using “extraordinary measures” to avoid default, which could tide the U.S. over until sometime in June.

The Federal Reserve has been shrinking its balance sheet since June 2022 as it sought to tighten financial conditions in an effort to lower inflation. At the same time, the U.S. central bank has raised its policy rate by 425 basis points last year, another lever to reduce demand.

Commercial bank reserves kept at the Fed serve as foundation for the U.S. financial system. With the Fed’s QT program in 2018 and 2019, stocks dropped and money markets froze when reserves dropped.

Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets, told Bloomberg that, “there’s really two major sources of uncertainty around this process. We don’t know what the right level of reserves is” or how long it will take to reach that level. In addition, the debt limit “adds uncertainty around the pace” of reaching that end level.

The Fed’s QT process can reduce liquidity through two mechanisms — bank reserves and the reverse repurchase facility, or RRP, which essentially holds money for money market funds. Which one shrinks can matter as reserves are seen as having a more powerful influence in supporting credit.

As the Treasury’s cash holdings dwindles and sales of government securities are restrained, there will be a smaller supply of Treasury bills for money market funds. That’s likely to lead money market funds to funnel more money into the reverse-repo facility, Bloomberg said. In turn, that could end up shrinking bank reserves faster.

“All of this cash is going to be put to work in the Fed’s RRP facility,” John Velis, a foreign exchange and macro strategist at BNY Mellon, told Bloomberg. “That will bring down reserves, as it’s a mirror image.” If reserves get too low, markets could experience “some hiccups,” he added.

Last week, New York Fed President told reporters that Fed officials are monitoring risks concerning the debt limit and potential affects on reserve balances.

SA contributor JD Henning takes a look at the debt ceiling, extraordinary measures, the Fed’s QT program, and what it all means for sectors and markets.

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