A fresh wave of volatility threatens the battered U.S. Treasury market — and this time it’s all thanks to the Federal Reserve’s ambitious bid to shrink its $9 trillion balance sheet just as it raises interest rates.
In less than two weeks, the U.S. central bank is expected to lay out a template for the process known as quantitative tightening, with Fed Chair Jerome Powell signaling the final plan may be unveiled on May 4.
Powell has telegraphed a faster pace of QT is coming than the 2017-2019 episode — the market’s only previous experience with a Fed on a mission to pare asset holdings. It ultimately ended that liquidity-tightening runoff after funding problems emerged in money markets.
This time around, strategists see a fresh set of challenges.
The removal of the Fed as the giant marginal buyer of Treasuries threatens to exacerbate weakened trading conditions caused by big banks limiting their market-making — something that’s been a backdrop to the most recent volatility. And, combined with rate hikes, QT could spur investors to insist on higher premiums to hold longer-dated debt, some experts say.
“The next test of markets will be anything out about QT,” said Yvette Klevan, portfolio manager in the global fixed-income team at Lazard Asset Management. Investors will be looking to understand its impact on “trading and flow dynamics in the Treasury market,” she said.
Treasuries are on course for their worst quarterly rout since at least 1973, with 10-year yields up more than three quarters of a percentage point, as Fed officials embrace the potential need for half-point hikes. Powell said earlier this month that minutes of the March 15-16 policy meeting — expected around April 6 — will have more information about balance-sheet runoff plans.
The news will come amid continuing liquidity issues that have contributed to sharp moves in Treasuries, with market participants less willing to trade older securities. That’s in part because of regulations requiring banks to set aside capital for holding government debt.
“The real test is going to be how does the market react to actual supply and demand that will be forthcoming” with the Fed no longer buying new Treasuries while soon winding down its current holdings, said Steven Oh, global head of credit and fixed income at PineBridge Investments LP, which manages about $149 billion in assets.
Assets on the Fed’s balance sheet now amount to about $9 trillion, including over $5.7 trillion of Treasuries and $2.7 trillion in agency mortgage-backed securities.
The Treasury Borrowing Advisory Committee, a panel of top bond dealers and investors that confers with the Treasury Department, early last month penciled in a $320 billion contraction in the Fed’s bond portfolio this year, starting in July. But that came before the latest guidance from Powell and his colleagues about moving faster to rein in the worst inflation in four decades.
“We have not received much guidance from the Fed on what this might look like,” Matthew Luzzetti, chief U.S. economist at Deutsche Bank Securities Inc., said of the QT plan. “That leaves potential for some disconnect between what the market is anticipating and what the Fed eventually delivers.”
Cash Rich
Deutsche Bank’s forecast — on the hawkish end of the spectrum of projections — sees QT starting in June, with $800 billion of runoff this year and another $1.1 trillion in 2023, adding up to the equivalent of about three or four quarter-point rate hikes.
On the positive side, strategists see little risk of the kind of funding pressures seen in September 2019. That’s because banks are flush with over $5 trillion in reserves. There’s so much extra cash that financial institutions have parked some $1.8 trillion at the Fed in the form of reverse repos.
Still, even those who see the market steadily pricing in the balance-sheen runoff expect higher yields. Gargi Chaudhuri, head of BlackRock Inc.’s iShares investment strategy, for example, sees 10-year yields climbing as high as 2.75% in coming months, from about 2.29% late Wednesday.
Under the combined pressure of rate hikes and QT, investors may in time demand higher term premiums to buy longer-dated securities -- the so-called term premium, according to John Roberts, an analyst who served more than three decades as a Fed economist.
“The normalization of the balance sheet might boost the term premium by about 85 basis points,” Roberts wrote in a post Tuesday. That’s up from an estimated negative 35 basis points as of Monday.
When the Fed reinvests maturing Treasuries, it does so through add-ons to the Treasury’s public auctions -- reducing the amount of debt the government has to borrow from the public. The ending earlier this month of the Fed’s secondary-market purchases as part of its quantitative-easing program could already be having an effect.
Since some buyers might have been participating until recently with the knowledge they could re-sell to the Fed, auctions could be key to monitor for potential impact from QT.
Another dynamic to consider: the Fed’s $326 billion stockpile of Treasury bills. While in 2017 the central bank owned no bills, this time round, focusing any runoff on bills could ease the impact on notes and bonds, at least initially, given their maximum tenor of just one year.
The Fed meantime will still be reinvesting some proceeds from maturing securities. Powell has signaled there will be monthly caps on balance-sheet contraction, as used last time. But another point to watch in the forthcoming plan is how reinvestments will occur, and whether bills will be part of the monthly caps.
All that uncertainty suggests ample room for volatility to lash the Treasury market anew. And the Fed has plenty of options to dial QT up and down. At some point, officials could focus the reinvestment money on bills, rather than back into coupon-bearing securities -- allowing for an acceleration in QT. If mortgage rates and other key borrowing costs remain too low, that could be an option for policy makers as they battle to bring down inflation, said Andrew Hollenhorst, chief U.S. economist at Citigroup Inc.
“The Fed will be attuned to financial market functioning issues, but the driving goal for Fed officials right now is to return to price stability — to bring inflation down,” Hollenhorst said. “They are looking for all the levers they can pull to do this.”
