Liquidity issues and Treasury market volatility could derail the Fed’s balance sheet reduction

by Michael Maharey 0 0

Interest rate hikes get the most attention as the Federal Reserve fights inflation, but balance sheet shrinking is arguably more important. And it’s not going well.

Since the Fed stopped buying Treasuries and started letting bonds fall off its books as they matured, the bond market has experienced increasing volatility and liquidity problems. In fact, there is already talk of the possibility that the central bank will abandon the quantitative tightening.

Since the Fed launched its first quantitative easing (QE) program in the wake of the 2008 financial crisis, it has purchased more than $8 trillion in US Treasury bills and mortgage-backed securities.

Indeed, the Fed has monetized trillions of dollars of government debt, first in the wake of 2008 and then again during the pandemic. Through various QE programs, the Fed has bought bonds with created money, creating artificial demand for Treasuries. Central bank bond buying keeps the price up and keeps bond yields artificially low. This allows the US government to sell more bonds than it could without Fed intervention. Without the Fed’s big thumb in the bond market, Uncle Sam would have a hard time maintaining his lending and spending policies. Interest rates would rise too much to make further lending sustainable.

It’s starting to happen today.

When the Fed initiated quantitative tightening, the artificial demand it created disappeared. As a result, bond prices have plummeted and interest rates have risen. This is not a good scenario for a US government with more than $31 trillion in debt.

As the Fed performs QE, the new money it creates to buy bonds finds its way into the economy. This is the definition of inflation. The only way the Fed can deal with inflation is to stop creating money and remove the excess it has created from the economy. Quantitative strengthening (QT) is a key part of this process. If the Fed were serious about fighting inflation, it would not only let maturing bonds be written off its balance sheet, but it would also sell Treasuries on the open market. This would shrink the Fed’s balance sheet and withdraw excess dollars from the economy. But central bankers know they can’t do it without crashing the Treasury market.

In May, the Fed announced a QT program as the CPI started to move higher. Under the plan, the Fed is expected to reduce the balance sheet by $95 billion a month. That’s up from $47.5 billion before September. Based on the Fed’s plan, it would take the central bank more than seven years to reduce the balance sheet to pre-pandemic levels. And it’s even below that target. To date, the Fed has only managed to meet or exceed its target once (August) in six months.

But even this tepid QT program is causing problems in the Treasury market.

According to a recent Reuters report, “The ongoing US Federal Reserve balance sheet draw has exacerbated tight liquidity and high volatility in the $20 trillion US Treasury debt market, raising questions as to whether the Fed should rethink this strategy.”

A bond analyst said Reuters that volatility could force the Fed to return to QE.

It is certainly conceivable that if bond volatility continues to increase, we could see a repeat of March 2020. The Fed will be forced to end its QT and buy a large amount of Treasuries.”

UBS economists said the Fed could be forced to end QT by mid-2023.

This is not good news for those who expect the Fed to win the battle against inflation. Going back to QE is literally going back to inflation.

Reuters explained the liquidity problem.

A key indicator that investors monitor is the liquidity premium of on-the-run Treasuries, or new issues, over off-the-run Treasuries, which are older Treasuries that account for the majority of total debt outstanding, but they make up only about 25% of the daily trading volume. On-the-run Treasuries typically command a premium over off-the-run Treasuries in times of market stress. Data from BCA Research showed 10-year on-the-run premiums relative to their off-the-run counterpart are at their highest since 2015. Morgan Stanley said in a research note that off-the-run liquidity it is most affected in the US 10-year bonds, followed by 20-year and 30-year bonds, as well as five-year bonds.

The only thing the Fed can do to alleviate the problem is go back to buying bonds. If the market starts to crash, that’s almost certainly the way it will go.

Again, and I can’t stress this enough, the Fed cannot simultaneously fight inflation and implement quantitative easing.

One analyst conjured up the conundrum in front of the Fed.

Herein lies the dilemma. If the Fed shrinks the SOMA (system open market account) portfolio too much, it will break something in the market. If they don’t, we’re stuck with inflation.

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