BofA Merrill Lynch writes "Fed portfolio rundown impact on bank reserves and money markets." The piece says, "Chair Yellen's recent semi-annual congressional testimony reiterated core elements of the Fed's likely approach to balance sheet reduction, including that the balance sheet will decline in a gradual manner and that the Fed will rely on short-term interest rates as the primary tool for monetary policy. These comments were in line with our expectations for the Fed's portfolio.... When the Fed allows its balance sheet to decline, it will have important implications for the private banking sector and money markets. We expect the initial reduction in excess reserves will primarily come from foreign banks that hold reserves for opportunistic purposes and that have seen their reserve holdings decline in recent years (Chart of the Day). In our view, such a reserve reduction will likely result in: (1) reduced transaction volumes in overnight unsecured money markets, (2) limited incremental demand for high-quality liquid assets from domestic banks, and (3) increased buying of new Treasury issuance from non-bank sources, including government money market mutual funds." The article adds, "If bank HQLA-related Treasury buying is limited, then the Treasury will need to find other sources of demand to fund their increased issuance as the Fed's portfolio winds down. Recall, as the Fed's Treasury holdings mature, the Office of Debt Management will need to increase issuance in order to raise funds that can be used to pay back the Fed. We expect the Treasury could find strong demand from government-related money market mutual funds in this regard. The Office of Debt Management will likely look to offset any reduction in the Fed's Treasury holdings through new issuance concentrated at the front-end of the curve, including increased bill supply."

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