The Fed's Balance Sheet Normalization: Implications for Global Financial Stability and Fixed-Income Markets

The Federal Reserve's balance sheet normalization, initiated in June 2022, has entered a critical phase as it navigates the delicate balance between reducing excess liquidity and preserving financial stability. As of March 2025, the Fed's balance sheet stood at $6.7 trillion, down $340 billion from September 2024, reflecting a gradual but deliberate approach to quantitative tightening (QT) QT, Ample Reserves, and the Changing Fed Balance Sheet^[1]. This process, aimed at transitioning from an "abundant" to an "ample" reserves regime, has far-reaching implications for both U.S. and global financial markets.

U.S. Context: A Delicate Tightrope

The Fed's normalization strategy hinges on adjusting reinvestment caps for maturing securities. In March 2025, the FOMC reduced the monthly redemption cap on Treasury securities from $25 billion to $5 billion while maintaining the $35 billion cap for agency debt and mortgage-backed securities (MBS) QT, Ample Reserves, and the Changing Fed Balance Sheet^[1]. This slowdown underscores the Fed's caution in avoiding liquidity strains, particularly as reserve balances have fallen to $3.2 trillion—a level still consistent with the "ample" threshold (estimated at 10%-11% of GDP) Fed Balance Sheet Normalization and the Minimum Level of Ample Reserves^[2].

Key indicators suggest that the Fed's approach has so far succeeded in maintaining stability. The spread between the effective federal funds rate (EFFR) and the interest on reserve balances (IORB) has remained stable, signaling that reserves remain ample Balance Sheet Normalization: Monitoring Reserve Conditions and Repo Market Pressures^[3]. However, repo market pressures have emerged as a concern, with a growing share of repo transactions priced at or above IORB. This reflects shifting demand dynamics, partly driven by increased Treasury issuance and the shrinking size of the Fed's System Open Market Account (SOMA) portfolio Balance Sheet Normalization: Monitoring Reserve Conditions and Repo Market Pressures^[3].

Global Implications: Spillovers and Systemic Risks

The Fed's normalization process reverberates globally, particularly in fixed-income markets. The U.S. dollar's dominance and the scale of the Treasury market mean that shifts in U.S. monetary policy generate significant risk spillovers. For instance, countries like China, which are net receivers of U.S. risk spillovers, face heightened volatility in their financial markets as they align with U.S. policy rate changes The spillover effect of US monetary policy on the international^[4]. Peripheral economies with limited monetary policy independence are especially vulnerable, as U.S. tightening can exacerbate capital outflows and pressure local bond yields.

Moreover, liquidity conditions in the U.S. Treasury market amplify global market responses. When U.S. Treasury liquidity is constrained—such as during periods of elevated issuance or repo market stress—the impact of Fed policy on international bond yields intensifies US Treasury market conditions and global market^[5]. For example, the narrowing yield spread between U.S. Treasuries and German Bunds in 2024 reflected shifting fiscal policies in Europe and the anticipation of Fed rate cuts US Treasury market conditions and global market^[5].

Risks and the Path Forward

While the Fed's cautious approach has mitigated immediate risks, several challenges loom. The Treasury General Account (TGA) has reached historically low levels, raising concerns about potential liquidity shocks if fiscal operations intersect with QT Descending Carefully: Challenges to the Federal Reserve's Smooth Runoff of Quantitative Tightening^[6]. Additionally, the Fed must monitor repo market frictions, which could evolve into systemic risks if demand for short-term financing outpaces supply.

The normalization process is expected to continue through late 2025 or early 2026, with the Fed aiming to stabilize reserves at a level consistent with its ample regime QT, Ample Reserves, and the Changing Fed Balance Sheet^[1]. However, defining "ample" remains an evolving task, as market conditions and economic growth dictate the threshold. The Fed's decision to halt QT will depend on reserve stability and financial market resilience, with no predetermined targets for reserve levels relative to GDP or bank assets Fed Balance Sheet Normalization and the Minimum Level of Ample Reserves^[2].

Conclusion

The Fed's balance sheet normalization is a pivotal step in restoring a conventional monetary policy framework. Domestically, it has succeeded in maintaining ample reserves while avoiding liquidity strains. Globally, however, the process underscores the interconnectedness of financial systems and the need for vigilance against spillover risks. As the Fed edges closer to its target, investors must remain attuned to both U.S. policy signals and international market dynamics—a landscape where liquidity, volatility, and cross-border capital flows will continue to shape outcomes.