2022 – Treasury market faces liquidity risk as Fed shifts Reuters balance sheet

© Reuters. FILE PHOTO: The Federal Reserve Building in Washington, US on January 26, 2022. Photo: Joshua Roberts/Reuters

By Karen Brittle

(Reuters) – As the Federal Reserve begins to mature bonds on its $9 trillion balance sheet, the most important metric to watch will be whether Treasury volatility in a market already experiencing phases of declining liquidity has paid off.

So-called quantitative tightening from the Federal Reserve (QT) could also push yields higher, although analysts say it will depend on the direction of the economy, among other things.

The Fed will mature the bonds from its balance sheet without replacement starting June 1 as it seeks to normalize monetary policy and curb rising inflation. This follows unprecedented bond purchases from March 2020 to March 2022 aimed at mitigating the economic impact of business shutdowns during the pandemic.

But as the world’s largest holder of US Treasuries reduces its presence in the market, some fear that its diluting effect is missing as a stable, price-sensitive buyer may worsen market conditions.

“The impact of the QT will be more pronounced in places like money markets and how the market works than in yield levels and curves,” said Jonathan Cohn, head of price trading strategy at Credit Suisse in New York, adding that he was “continuing.” The way this is done is through deposits, through withdrawals of liquidity and through the additional burden it places on traders.”

The Fed is withdrawing at a time when the Treasury market is already grappling with bouts of choppy trading. The issuance of US Treasuries has skyrocketed as banks face greater regulatory restrictions that they say have hampered their ability to intervene.

“On a side note, we could see slightly weaker liquidity in the Treasury market because there is no way to resell bonds from traders’ balance sheets to the Federal Reserve,” said Jay Lepas, senior fixed income analyst at Philadelphia-based Janie Montgomery Scott. “That could increase volatility, but liquidity is already weak even in interest rates and that’s not necessarily directional.”

Banks have reduced bond purchases this year. Some hedge funds have also scaled back their presence after being burned by losses during bouts of volatility. Foreign investors also showed less interest in US debt with higher hedging costs and higher foreign bond yields providing more options.

To the extent that the Fed’s withdrawal affects yields, they are likely to be higher. Many analysts believe that the Fed kept benchmark yields artificially low, which contributed to a short inversion of the Treasury yield curve in April.

“The risk is that the market can’t absorb the extra supply and you have to make a major valuation adjustment,” said Gennady Goldberg, chief US interest rate analyst at TD Securities in New York. “We’re still seeing more long-term supply than we did before COVID for some time, so everything should stay the same, which makes the print rates a little higher and the curve steeper.”

However, the yield trend is still influenced by other factors, including expectations of a Fed rate hike and the economic outlook, which could outweigh any impact from QT.

“From a top-down macroeconomic perspective, we think the other determinants will be just as important or even more important in thinking about the direction of returns,” said Credit Suisse’s Cohn.

The last time the Fed cut its balance sheet, it ended badly. Loan interest rates in the major overnight repo market rose sharply in September 2019, which analysts attributed to very low bank reserves when the Fed trimmed its balance sheet from October 2017.

This is less likely this time around now that the Fed has put in place a permanent repo facility that will serve as a permanent underpinning for the important funding market.

There is also a large excess of liquidity in the form of bank reserves and cash loaned to the Federal Reserve’s Reverse Repo Facility, which may take time to clear. Bank reserves stand at $3.62 trillion, up sharply from $1.70 trillion in December 2019. Demand for the Fed’s reverse repo facility, which sees investors buying government bonds overnight from federal borrowing, hit a record high of more than $2 trillion last week. .

The Fed is also taking time to increase its monthly borrowing limit of $95 billion, which it will take off its balance sheet every month. This will include $60 billion in Treasuries and $35 billion in mortgage-backed debt and will become fully effective in September. Those caps would be $30 billion and $17.5 billion, respectively, by then.

“It’s going to be very gradual…it’s too early to tell what impact QT will have,” said Subhadra Rajappa, head of US interest rate strategy at Societe Generale (OTC:) in New York, noting that there are no problems that may not emerge until the fourth quarter.