The Fed's balance sheet reduction expectations heat up combined with the 2026 interest rate cut outlook, leading the market to reprice the policy cycle and liquidity environment.

Huitong Finance App News—— The Federal Reserve’s balance sheet issue has returned to the center of market attention. The macro strategy team at Bank of New York Mellon pointed out that, as the policy environment changes, discussions about the balance sheet runoff path and the level of reserves will continue to heat up. In the Federal Reserve’s current balance sheet, bank reserves have become the largest liability item, and their size even exceeds the currency in circulation—making reserve management a key variable in the balance sheet runoff process.

From the perspective of policy preferences, several Federal Reserve-related figures have already clearly expressed their desire to shrink the size of the balance sheet in the coming years. Officials, including Kevin Walsh, who has been nominated as a candidate for Federal Reserve chair, tend to pursue this goal by reducing the supply of reserves in the system. This approach suggests that in the future, the Federal Reserve may place more emphasis on liquidity withdrawal, rather than relying solely on assets running off naturally due to maturities.

John Willis, a macro strategist at Bank of New York Mellon, said: “The balance sheet and reserves are closely linked. The core of future policy discussions will revolve around how to achieve balance sheet contraction while keeping volatility under control.”

At the operational level, the market is focused on the “three-way dilemma of the balance sheet.” This framework holds that if a central bank wants to shrink its balance sheet, it usually needs to strike a trade-off between rising volatility in money markets and frequent interventions. However, some policymakers have proposed a new path: achieving the balance sheet runoff goal by lowering the structural demand of banks for reserves, thereby not significantly increasing market volatility.

Meanwhile, expectations for the interest-rate path are also changing. Bank of New York Mellon maintains its view that the Federal Reserve may begin an easing cycle in the second half of 2026. This forecast differs somewhat from current market pricing, showing that uncertainty about policy expectations remains relatively high.

The realization of this easing path depends on multiple prerequisite conditions. First, the situation in the Middle East gradually stabilizes, thereby reducing pressure from energy prices; second, key input costs fall, helping ease inflation pressures; and finally, there are signs that the U.S. labor market is cooling. Only with these factors working together can there be room for a policy shift.

Analysts noted: “The market is still cautious about the interest-rate cut path, but if inflation and employment data weaken in sync, the window for a policy shift will gradually open.”

In terms of market reaction, the interest-rate market has already shown a certain degree of expectation adjustment, and traders have started to re-evaluate future policy paths. This “repricing” process will not only affect bond yields, but also trigger ripple effects across the U.S. dollar, gold, and risk assets.

From a technical perspective, U.S. Treasury yields show signs of retreat after having spiked earlier. Momentum has weakened on a daily chart level, indicating that market expectations for further rate hikes are becoming more cautious. Short-term support is gradually appearing, but overall the market is still in a high-level range-bound consolidation zone. On a 4-hour timeframe, yields are presenting a consolidation pattern; momentum indicators are falling. If subsequent data continues to weaken, it may further open up downside space.

Editor’s Summary

Overall, the Federal Reserve’s balance sheet reduction and the future rate-cut path are becoming the two main storylines the market is watching. On the one hand, balance sheet runoff means liquidity conditions are tightening, which could create potential pressure for the market; on the other hand, if inflation and economic data weaken, rate-cut expectations will gradually strengthen, providing support for the market. At the current stage, policy expectations still have significant uncertainty, and the market is in a process of dynamic adjustment. Future trends will depend on geopolitical developments, inflation changes, and performance in the employment market. Investors should closely monitor marginal changes in policy signals and macro data.

(责任编辑：王治强 HF013）

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