National Bank of Canada’s Taylor Schleich and Ethan Currie say the Federal Reserve has limited room to cut its balance sheet much further under current rules. The balance sheet is about $6.5 trillion after earlier quantitative tightening QT.
They state that the Fed’s liabilities set the size of its assets with key limits coming from bank reserves and the Treasury General Account TGA. Currency demand also tends to rise as the economy grows which supports a larger liability base.
Constraints On Further Balance Sheet Reduction
They argue that reducing the demand for reserves would mainly require regulatory change which could allow banks to hold more Treasuries and permit a smaller Fed portfolio. They note this could also raise risks if Treasuries move from a stable holder to riskier holders.
They expect QT not to restart with only small changes to how the Fed reinvests maturing securities. Since QT ended they note that outright US Treasury buying has been limited to Treasury bills which has reduced the duration of the Fed’s holdings.
We are seeing that the Federal Reserve has very little room to shrink its balance sheet further from the current $6.5 trillion level. Key liabilities like bank reserves which have stabilized around $3.3 trillion and a consistently high Treasury General Account are effectively boxing them in. This suggests the era of significant quantitative tightening we saw end back in 2025 is firmly behind us.
Without financial deregulation to lessen banks demand for reserves any further asset sales risk serious funding market stress. We all remember the repo market spike in September 2019 which showed what happens when reserves become scarce. The Fed will likely choose a large balance sheet over a repeat of that volatility.
Implications For Volatility And Curve Positioning
For derivative traders this outlook suggests that a major source of systemic tightening is off the table which should suppress long term volatility. The VIX has already been drifting lower recently trading in a tight range between 13 and 15 through January 2026. This environment looks favorable for strategies that profit from calm such as selling strangles on major indices or shorting VIX futures.
We also expect the Fed to continue managing its portfolio duration by reinvesting proceeds into T bills a strategy we observed them using in late 2025. This action should put gentle persistent steepening pressure on the yield curve. Traders could position for this by using SOFR futures to express a view that longer term rates will rise relative to shorter term ones.
