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I fail to understand how the reduction in bank excess reserves due to the Fed slowly reducing its balance sheet is linked to a squeeze to liquidity and funding.

The Treasury will have to raise issuance to fund the Fed's portfolio run-off. This means that the private sector will have to absorb additional liquidity in the market. Is the reason why liquidity is being squeezed due the Treasury competing with funding demands?

Banks will have to replenish reduction in excess reserves to maintain HQLA so there should be demand for increased Treasury supply...

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Lots of questions here. The reason why there was a liquidity squeeze in H1 2018 was most probably due to the large issuance of Treasury Bills, as the US Treasury replenished its cash balances following the reduction thereof during the debt ceiling debate of late 2017. This "liquidity squeeze" manifested itself in increased Libor-Fed Funds spreads, as participants decided to buy the bills instead of corporate and bank CP, thereby moving Libor wider.

The broader question of what happens when the Fed reduces balance sheet, is unclear because we've never seen it before. At first glance, it might seem that the excess reserves will simply be replaced with Treasury bills and bonds, since these are HQLA just like excess reserves. However it does appear that banks may be unwilling to accept Treasuries as a replacement for excess reserves, in which case we can expect upward pressure on Fed Funds rates as banks continue to demand excess reserves.

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