The federal funds rate, or what banks charge each other to borrow excess bank reserves, has risen in the past couple of days, likely due to reduced excess reserves in the US banking system, they said.
If the fed funds rate remains at elevated levels, it could complicate the Fed's current path to shrink its $4 trillion balance sheet by half in late 2020.
The decline in excess reserves, currently at $1.9 trillion, stemmed partly from the Fed's normalization of its some $4 trillion balance sheet, TD rates strategists Priya Misra and Gennadiy Goldberg said.
"The banking system as a whole may have enough reserves, but some banks may be paying up for fed funds," they wrote in a research note.
The average or "effective" fed funds rate (EFFR) was 1.92 percent on Thursday, only 3 basis points below the interest rate that the US central bank pays on excess reserves.
Last week, the Fed made an adjustment to the interest on excess reserves (IOER) by raising it by 0.20 percentage point, compared with a 0.25 point increase on the fed funds rate.
This technical tweak is seen as a move to discourage banks from borrowing reserves at the lower fed funds rate and profiting on higher IOER by leaving the reserves at the central bank. The tweak's goal is to encourage banks to lend rather than playing this rate arbitrage.
TD shared this view of another possible IOER adjustment with Bank of America Merrill Lynch, another US primary dealer.
"The continued EFFR increase poses problems for the Fed," Bank of America Merrill Lynch rates strategist Mark Cabana and Olivia Lima wrote in a research note on Thursday.
However, William Dudley, who stepped down as head of the New York Federal Reserve last week, downplayed the shrinking spread between EFFR and IOER.
"I think it's an interesting question from a monetary policy perspective, but I don't think it has huge ramifications for the economy, the financial system, or the economic outlook," Dudley told reporters a week ago on a conference call.
TD's Misra and Goldberg reckoned the next IOER adjustment may come as early as September if the Fed decides to raise rates again.
If EFFR were to trade close to parity to IOER by the end of 2018, this might force Fed policy-makers in early 2019 to consider ending the central bank's balance sheet normalization earlier than expected in order to avert funding stress the bank system due to falling excess reserves. Currently, traders expect the Fed's portfolio run-off to stop at the end of 2021.