Analysis: Fed shrinks balance sheet, Treasury market faces liquidity risk

The Federal Reserve Building is seen in Washington, USA on January 26, 2022. REUTERS/Joshua Roberts/File Photo/File Photo

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May 31 (Reuters) – As the Federal Reserve begins to let the bonds on its $9 trillion balance sheet mature, a key indicator to watch will be whether U.S. Treasury volatility will be affected by markets already suffering from low liquidity. exacerbated.

The Fed’s so-called quantitative tightening (QT) could also push yields higher, though analysts said it would depend on factors such as the direction of the economy.

Starting June 1, the Fed will allow bonds to mature off its balance sheet without replacement as it tries to normalize policy and reduce soaring inflation. This follows unprecedented bond purchases from March 2020 to March 2022 aimed at mitigating the economic impact of business closures during the pandemic.

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But as the world’s largest holder of U.S. government bonds reduces its presence in the market, some fear its lack of restraint as a consistent, price-insensitive buyer could worsen market conditions.

“The impact of QT will be more pronounced in areas such as money markets and market functioning, rather than yield levels and curves,” said Jonathan Cohn, head of rates trading strategy at Credit Suisse in New York, adding that he will focus on ” The way it does it through deposits, liquidity withdrawals and the extra burden it puts on traders.”

The Fed is retreating at a time when the U.S. Treasury market is already struggling in choppy trading. U.S. government bond issuance has soared, while banks face greater regulatory constraints, which they say hinder their ability to conduct intermediary transactions.

“On the margin, we could see a little less liquidity in the U.S. Treasury market because there is no opportunity to sell the bonds on dealers’ balance sheets to the Fed,” said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia. “That could increase volatility, but liquidity within the interest rate space is also already thin, which is not necessarily directional.”

Banks have scaled back bond purchases this year. Some hedge funds have also reduced their presence after suffering losses during periods of volatility. Foreign investors’ appetite for U.S. bonds has also declined as hedging costs have risen and rising foreign bond yields have provided more options.

To the extent that the Fed retreat does affect yields, it is likely to be higher. Many analysts believe the Fed has kept benchmark yields artificially low and contributed to a brief inversion of the U.S. Treasury yield curve in April.

“The risk is that the market can’t absorb the extra supply, and valuations do adjust quite a bit,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities in New York. “We’re still going to see more long-term supply than pre-COVID for quite some time, so other things being equal, the stress rate should be a bit higher and the curve a bit steeper.”

However, the direction of yields will still be influenced by other factors, including expectations of Fed rate hikes and the economic outlook, which could outweigh any impact from QT.

“From a top-down macro perspective, we think other determinants are just as, if not more, important in considering yield direction,” said Credit Suisse’s Cohen.

The last time the Fed shrank its balance sheet, it turned out badly. Borrowing rates in the key overnight repurchase agreement market surged in September 2019, which analysts attributed to the Federal Reserve’s balance sheet shrinking from October 2017, which caused bank reserves to fall too low.

That’s unlikely to happen this time around after the Fed established a standing repo facility that will serve as permanent support for key funding markets.

There is also a large excess of liquidity in bank reserves and cash borrowed into the Fed’s reverse repo facility, which may take time to resolve. Bank reserves stood at $3.62 trillion, up sharply from $1.70 trillion in December 2019. Demand for the Fed’s overnight reverse repo facility hit a record of more than $2 trillion last week, with investors borrowing U.S. Treasuries from the Fed overnight.

The Fed is also taking time to raise the monthly cap on bonds to $95 billion and allow monthly rollouts from the balance sheet. This will include $60 billion in U.S. Treasury debt and $35 billion in mortgage-backed debt, and will be fully effective in September. Until then, those caps will be $30 billion and $17.5 billion, respectively.

“It’s going to be very gradual … it’s too early to know what impact QT will have,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale in New York, noting that any problems may not start until the fourth Season just surfaced.

(This story re-added “as” in the first paragraph)

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Reporting by Karen Breitel; Editing by Alden Bentley and David Gregorio

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