Treasury Market Liquidity and Volatility Problems Could Derail Fed Balance Sheet Reduction

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Interest rate hikes get most of the attention as the Federal Reserve fights inflation, but balance sheet reduction 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 mature, the bond market has experienced increasing volatility and liquidity problems. In fact, there is already talk about the possibility of the central bank abandoning 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 bonds and mortgage-backed securities.

In effect, the Fed monetized trillions of dollars in government debt, first in the wake of ’08 and then again during the pandemic. Through various QE programs, the Fed bought bonds with money created out of thin air, creating an artificial demand for Treasuries. Central bank bond buying holds the price up and keeps bond yields artificially low. This allows the US government to sell more bonds than it could without the Fed’s intervention. Without the Fed’s big fat thumb on the bond market, Uncle Sam would have a hard time maintaining its borrow and spend policies. Interest rates would rise too high to make further borrowing tenable.

That’s beginning to happen today.

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

As the Fed runs QE, the new money that it creates to buy bonds finds its way into the economy. This is the definition of inflation. The only way the Fed can tackle inflation is to stop creating money and remove the excess it created from the economy. Quantitative tightening (QT) is a key part of this process. If the Fed was really serious about fighting inflation, it would not only let maturing bonds roll off its balance sheet, but it would also sell Treasuries into the open market. This would shrink the Fed balance sheet and pull excess dollars out of the economy. But the central bankers know they can’t do that without collapsing the Treasury market.

In May, the Fed announced a QT program as CPI began to climb. According to the plan, the Fed is supposed to be reducing the balance sheet by $95 billion a month. This is up from $47.5 billion before September. Based on the Fed plan, it would take over seven years for the central bank to reduce the balance sheet to prepandemic levels. And it’s even falling short of that goal. To date, the Fed has only succeeded in meeting or exceeding its goal one time (August) in six months.

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

According to a recent Reuters report, “The US Federal Reserve’s ongoing balance sheet drawdown has exacerbated low liquidity and high volatility in the $20-trillion US Treasury debt market, raising questions on whether the Fed needs to re-think this strategy.”

One bond analyst told Reuters that the volatility could force the Fed to pivot back to QE.

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

UBS economists said the Fed may be forced to end QT by the middle of 2023.

This is not good news for those expecting the Fed to win the inflation fight. Going back to QE literally means a return to inflation.

Reuters explained the liquidity problem.

A key indicator that investors track is the liquidity premium of on-the-run Treasuries, or new issues, compared with off-the-runs, which are older Treasuries representing the majority of total outstanding debt, but make up only about 25% of daily trading volume. On-the-run Treasuries typically command a premium over off-the-runs in times of market stress. BCA Research data showed that 10-year on-the-run premiums over their off-the-run counterpart are at their widest since at least 2015. Morgan Stanley in a research note said that off-the-run liquidity is most impaired in U.S. 10-year notes, followed by 20-year and 30-year bonds, as well as five-year notes.”

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

Again, and I can’t emphasize this enough, the Fed can’t simultaneously fight inflation and run quantitative easing.

One analyst summed up the conundrum facing the Fed.

Therein lies the dilemma. If the Fed runs down the SOMA (system open market account) portfolio too much, they will break something in the market. If they don’t, we are stuck with inflation.”

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