The Fed just hit pause on tightening, and may have unleashed its next big problem
The U.S. financial system is starting to feel a cash shortage, not for consumers, but for banks, investment firms, and money-market funds that move trillions of dollars daily to keep the country’s financial plumbing running smoothly.
The main catalyst, according to Apollo chief economist Torsten Slok, is the Federal Reserve’s balance sheet reduction, known as quantitative tightening (QT), combined with a surge in U.S. Treasury bill issuance to finance large federal deficits.
Under QT, the Fed allows the bonds it holds to mature without reinvesting the proceeds, which gradually withdraws reserves from the banking system. At the same time, the Treasury’s heavy issuance of short-term debt absorbs liquidity from money-market funds and banks, intensifying competition for cash across funding markets.
“The ongoing government shutdown has amplified this dynamic, as the Treasury General Account balance has risen with delayed federal spending, further draining reserves from the banking system,” Slok wrote.
With fewer reserves available, funding markets are now competing harder for cash, pushing overnight lending rates above the Fed’s Interest on Reserve Balances (IORB), a rate that normally acts as a floor for short-term funding costs.
When market rates rise above the IORB, it’s a signal that liquidity is running dry and the financial system is starting to feel stress in its plumbing. The SOFR rate climbed 12 basis points above IORB in late October, an unusual spread that has persisted, according to MacroMicro data.
For many analysts, this is the final domino before the Fed reverses QT, a move that could keep liquidity flowing through the financial system, albeit at a cost.
The Fed moves to end QT
At its October policy meeting, the Fed announced it would formally end QT and begin reinvesting maturing securities instead of allowing its balance sheet to shrink. According to Robin Brooks, a senior fellow at the Brookings Institution, the reinvestment process is expected to begin on Dec. 1.
The Fed on Oct 29 announced the end of QT and will shortly return to balance sheet expansion. This puts a lid on recent volatility in short-term rates, but that's a de facto subsidy for the basis trade, which is a big geopolitical vulnerability of the US.https://t.co/t4EGbqFbxc pic.twitter.com/Yh0vPHHdXe
undefined Robin Brooks (@robin_j_brooks) November 12, 2025
While the shift should calm turbulence in the funding markets, it also carries unintended consequences: “This puts a lid on recent volatility in short-term rates, but that’s a de facto subsidy for the basis trade, which is a big geopolitical vulnerability of the U.S.,” Brooks wrote.
The basis trade in Treasurys — a highly leveraged strategy that exploits small price differences between Treasury bonds and futures — relies on cheap, stable repo funding. By adding liquidity and keeping short-term borrowing costs low, the Fed effectively supports this trade, even if unintentionally.
Brooks warned that this dynamic gives foreign counterparties, particularly China, greater leverage over the U.S. financial system. The concern is that heavy reliance on foreign-funded leverage in Treasurys could expose the U.S. to geopolitical or market shocks if those flows suddenly reverse.
As both Slok and Brooks warned, the situation bears close watching, especially as trade tensions between the U.S. and China continue to escalate.