Down Debt

Analysis: Treasury market faces liquidity risks as Fed shrinks balance sheet

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

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May 31 (Reuters) – As the Federal Reserve prepares to let bonds mature on its $9 trillion balance sheet, the main metric to watch will be whether Treasury volatility picks up as a result of a market that already suffers from periods of low liquidity.

The Fed’s so-called quantitative tightening (QT) could also push yields higher, though analysts say that will depend on the direction of the economy, among other factors.

The Fed will let bonds mature on its balance sheet without replacement starting June 1 as it tries to normalize policy and bring down runaway inflation. This follows unprecedented bond purchases from March 2020 to March 2022, intended to mitigate the economic impact of business closures during the pandemic.

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But as the world’s largest holder of U.S. government debt shrinks its market presence, some worry that the absence of its dampening effect as a consistent, price-insensitive buyer could deteriorate market conditions.

“The impact of QT will be more evident in places like money markets and in market functioning as opposed to levels and yield curves,” said Jonathan Cohn, head of rates trading strategy at Credit Suisse at New York, adding that it will monitor “how it proceeds with deposits, cash withdrawals and the additional burden it places on dealers.

The Fed is backing down at a time when the Treasury market was already struggling with bouts of choppy trading. U.S. government debt issuance has soared as banks face greater regulatory constraints, which they say has hampered their ability to midstream transactions.

“On the margin, we could see a little lower liquidity in the Treasury market because there is no possibility of selling bonds from dealer balance sheets to the Fed,” said Guy LeBas, chief securities strategist. fixed income at Janney Montgomery Scott in Philadelphia. “It could increase volatility, but liquidity is also already quite thin in the rate space and it’s not necessarily directional.”

Banks have reduced their bond purchases this year. Some hedge funds have also reduced their presence after being burned by losses during bouts of volatility. Foreign investors have also shown less interest in US debt as hedging costs rise and a rise in foreign bond yields offers more options.

To the extent that the Fed pullback will impact yields, it will most likely be higher. Many analysts believed the Fed kept benchmark yields artificially low and contributed to a brief inversion of the Treasury yield curve in April.

“The risk is that the market won’t be able to absorb the additional supply and you’ll have a big adjustment in valuations,” said Gennadiy Goldberg, senior US rates strategist at TD Securities in New York. “We’ll see even more long-term supply than pre-COVID for a while, so all else being equal, that should pressure rates a bit higher and the curve a bit steeper.”

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

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

The last time the Fed reduced its balance sheet, it ended badly. Borrowing rates in the crucial overnight repurchase deal market jumped in September 2019, which analysts attributed to bank reserves falling too low as the Fed reduced its balance sheet from October. 2017.

It’s less likely this time around after the Fed put in place a permanent repo facility that will work as a permanent backstop for the crucial funding market.

There are also significant excess liquidity in the form of bank reserves and cash lent to the Fed’s reverse repo facility, which may take time to materialize. Bank reserves stand at $3.62 trillion, up sharply from $1.70 trillion in December 2019. Demand for the Fed’s overnight reverse repo facility, where Investors borrowing Treasuries from the Fed overnight set a record high of more than $2 trillion last week.

The Fed is also taking time to hit its monthly cap of $95 billion in bonds that it will allow to exit its balance sheet each month. This will include $60 billion in Treasury bills and $35 billion in mortgage-backed debt, and will come into full effect in September. These caps will be $30 billion and $17.5 billion respectively until then.

“It’s going to be very gradual… It’s just too early to tell if anything the impact is going to be from QT,” said Subadra Rajappa, head of US rates strategy at Societe Generale in New York, noting that any problems may not begin to surface until the fourth quarter.

(This story refiles to add “like” in the first paragraph)

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

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