COLUMN-Fed and US banks seem to be in different worlds: Mike Dolan

The Federal Reserve and U.S. banks appear to be operating in parallel universes. One sees tightening liquidity and the other seems awash with it. In an already puzzling year with multiple disconnects between seismic U.S. economic policy changes and the reaction of both the economy and financial markets, this week threw up another puzzle.

On Tuesday, Fed Chair Jerome Powell delivered a pointedly dovish speech, emphasizing a weakening labour market but also signs of tightening liquidity within money markets. The comments cemented market expectations of two more interest rate cuts by year-end, with little or no official economic data at the moment to contradict Fed assumptions due to the U.S. government shutdown.

But Powell also encouraged speculation that the Fed's "quantitative tightening" process - or the rundown of its bloated balance sheet of mostly Treasury bonds accumulated during the pandemic - would also end in the "coming months". The Fed has been slowing this runoff for some time, and markets had expected it to eventually stop early next year. But ending QT even sooner, along with the resumption of interest rate cuts, adds considerable support to a financial system that's already generating the loosest overall conditions in almost four years, near record-high stock prices and widespread suspicion of bubbles and froth across the financial and tech stock space.

As ever, the Fed's balance sheet management involves a complicated, if non-specific, series of metrics about what ample bank reserves may be, as well as monitoring use of standing Fed lending facilities, securities repurchase rates and even quarter-end funding quirks. Some of the pure excess liquidity generated by the pandemic rescues - and subsequently neutralised daily by the Fed's "reserve repo" operations - have been effectively burned off. The question is whether the overall balance sheet and bank reserve levels are now back at a sustainable "steady state". Powell seems to think liquidity is getting uncomfortable enough to not risk causing an accident and that the "steady state" may be even closer to hand than many had thought - even if the pace of QT has already been reduced to a mere $5 billion of Treasuries a month since March.

DIESEL ON FLAMES And yet the signalling seems odd coming the same day as the big U.S. banks published their latest quarterly results. Those touted not only boom-time investment banking and fee business but brisk corporate lending growth and numerous observations that some parts of financial markets may be overcooked. "We've had a credit market bull market now for the better part of since 2010. ... These are early signs there might be some excess out there because of it," JPMorgan boss Jamie Dimon said this week. He was referring to the twin collapse of First Brands and Tricolor last month that raised questions about private credit markets in particular but also lax conditions in general.

Global asset managers are also simultaneously flagging exuberant positioning as well as gnawing concerns about a related credit hiccup. Bank of America's latest fund manager survey showed investors rating liquidity conditions this month as their best since 2021 - holding their highest stock allocations in eight months and the lowest cash holdings in over a decade.

The biggest risks they identified? An AI bubble or a systemic event in "private equity/credit". So why do Powell and his colleagues seem so keen to pour more diesel on that fire right at this juncture?

Away from the AI frenzy and seemingly effervescent markets, the labour market is indeed weakening - albeit in a fuzzy way related to immigration curbs - and the Fed may be wary of how it unfolds a year from now. Might the central banks have spotted something more worrying coming down the pike - or is it getting darker readings on banking system liquidity than all the bank headlines and hoopla?

Perhaps the political pressure for easy money and support for the Treasury market is really just too much to resist, even as inflation continues to run hot in the 2.5% to 3.0% zone. Stephen Miran, who is on leave from the Trump White House to serve as the newest Fed governor, has been touting his view all week that neutral interest rates are far lower than most of his colleagues think and hence the Fed needs to get there soon to prevent being a drag on the economy.

Judging from the banks and the markets, and pre-shutdown economic readouts, there's little or no sign of that GDP drag, and if you believe all the AI advocacy then neutral rates could arguably be even higher. No wonder gold is still rocketing.

The opinions expressed here are those of the author, a columnist for Reuters -- Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn. Plus, sign up for my weekday newsletter, Morning Bid U.S. (by Mike Dolan; Editing by Jamie Freed)