As discussed in several notes this year and mentioned in the FOMC preview, the plethora of new liquidity programs that the Fed has put into place are creating balance sheet issues. The $30 billion that the Fed may be lending to JPM, plus whatever else it lends through the PDCF can be added to the list laid out on Friday.

The Fed has already liquidated over $100 billion of Treasury bills since last summer, and it feels like there is at least $100 billion more to go in the next month or two. Market participants need to be prepared for some potentially radical results.

First, the Fed’s T-bill portfolio is falling rapidly, having moved from $300 billion to less than $200 billion. I don’t know how low the Fed is willing to go, but if they do not want to let their bill holdings get below, say, $100 billion (the bill portfolio is the Fed’s buffer, since the Fed needs to be able to sell bills at any time in the event that it is hit with a surge in discount window borrowing), then we are fast approaching the point where more drastic measures will be necessary.

What else might the Fed do? The first innovation would probably be that the Fed will begin to play the overnight RP market from the short side. Since it is on its way to providing $100 billion in 28-day RPs and since dealers can go to the PDCF for overnight cash, the Fed may be in a better position to routinely do reverse RPs rather than RPs, i.e. to drain liquidity in its overnight operations rather than add to them.

Second, the Fed may have to start selling some of its Treasury coupon holdings. Given the lack of balance sheet and liquidity in the markets, this could get ugly for off-the-run Treasuries. Third, the end game is getting closer. If the situation fails to stabilize, the Fed will keep cutting the funds rate and keep finding more ways to add liquidity. Eventually, if the financial market situation fails to stabilize, the funds rate will reach a low level and the Fed will abandon funds rate targeting altogether and start adding to its balance sheet. This would be the point where it might start thinking about buying agency debt and agency MBS outright. Until the Fed abandons funds rate targeting, however, every provision of liquidity has to be offset, and the days of “easy” offsets (i.e. redeeming T-bills at auction) are fast dwindling, leaving the Fed with several less appealing options. We are still hopeful that we will not get to such a point, but obviously, we are moving closer and closer.