(Bloomberg) — The Treasury market is gearing up for potential disruptions from the next and most difficult phase of policymakers’ tough campaign: the shrinking of an $8.5 trillion bond portfolio.
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Minutes from the Federal Reserve’s May policy meeting showed that “many” policymakers see the risk of an “unforeseen impact” on markets from the US central bank’s plans to allow billions of dollars worth of bonds to mature without replacement each month. .
Already cashed in by the fastest trajectory of Federal Reserve interest rate hikes in decades, investors are now gearing up for what’s known as quantitative tightening, or QT. Fed Chairman Jerome Powell himself cautioned earlier this month that the process – seen as secondary to rate hikes – has an element of uncertainty surrounding it.
“It is actually because QT must be running in the background that makes it more dangerous,” said Priya Mishra, global head of rates strategy at TD Securities. By sending inflation-adjusted yields higher, it would reinforce consolidation in US financial conditions and slow the economy, she said.
Powell described the QT as having an “important role” in tightening monetary policy and said it would help return financial conditions to a “more neutral” calibration. Market participants have outlined several areas of potential stress as it occurs. Among them are the following:
As Mishra has outlined, this can push up long-term rates. The ten-year Treasury yield was up about 2.75% on Wednesday, up from 1.51% at the end of last year, and hit a high of 3.20% earlier this month, a level unseen since 2018.
While some believe that reward has already peaked, the effect of QT can be difficult to assess. The Fed is going to reduce its portfolio much faster in 2017-19 than in one of its previous episodes. Three months after the start of June 1, the Fed will allow up to $95 billion of securities to mature each month, compared to a maximum runoff of $50 billion last time.
Still the final effect remains uncertain.
“With regard to risks related to balance sheet reductions, a number of participants noted the potential for unforeseen impacts on financial market conditions,” the minutes of the Fed’s May 3-4 meeting, released on Wednesday, said.
Read more: Fed Saw Aggressive Hike Offers Resilience Later This Year
Still, giving officials some confidence to move fast is a safety net established last year. Permanent Repo Facility (SRF) gives market players a window where they can get cash against parking treasury. The idea is that it could help prevent a repeat of the repo-market turmoil of 2019, when rates in that crucial corner of the financial system soared amid a seizure in lending.
Charles Evans, president of the Federal Reserve Bank of Chicago, said in an interview at Bloomberg’s New York headquarters on May 18 that “the size of the balance sheet probably shouldn’t be that big”, noting SRF. But “I can’t tell you exactly how this will work. I don’t know how the permanent repo feature will work.
Some worry Qt may aggravate already stressful trading situations. Large US banks have avoided adding market-making capability to treasuries for years, thanks to the capital requirements involved. This contributes to sharp, sudden movements in yields. Starting next month, the Fed will now reduce its participation in buying auctions, and will have less to lend to others.
“Liquidity isn’t great and financial conditions are getting tighter before dealers need to intermediate these treasuries and mortgage-backed securities,” said Tim Wessel, strategist at Deutsche Bank AG.
While the Treasury Department is leading the effort to ease trading conditions, no detailed plans have yet emerged. “It seems that regulators thought they had more time to address this before Qt started,” Wessel said.
Fed officials themselves discussed a potential hit to Treasury market liquidity this month. The minutes show that several policymakers “noted that monetary policy tightening could interact with liquidity-related vulnerabilities of the markets for Treasury securities.”
Read more: Fed Flags QT’s Potentially Hit Treasury Market Liquidity
lack of overseas purchases
The global backdrop of Fed QT this time is quite different. The European Central Bank, along with most other major Fed peers, are joining the tightening in the US – another potential push for yields, suggesting lower global demand for bonds.
“When you consider what’s going to happen to the 10-year U.S. Treasury yield, you also have to realize that this is comparable to what’s happening globally,” said Zachary Griffiths, strategist at Wells Fargo Securities. Doesn’t differ.” “Last time in a Fed QT, there was a ton of buying going on by other central bank banks,” but that’s not the case now, he said.
mortgage bond risk
Another area of concern for some: outright sales from the Fed’s portfolio of mortgage-backed securities. Powell noted earlier this month that it is likely that the amount of MBS matured will be less than the Fed’s monthly cap. This opens up the possibility of a sale, if the policy makers so decide – something that was also mentioned within minutes.
The sale of MBS would make Qt “super-charged,” in Mishra’s view on TD.
This would be a surprising move given that the market is not currently priced in, said Gina Kuro, head of agency MBS Research at Bank of America Corp, who expects the Fed to begin selling off MBS Holdings next year.
Ankur Mehta, head of global securitized research at Citigroup Inc., sees sales begin as the fourth quarter, citing the potential for the Fed to return to a Treasury-only portfolio would allow for a gradual reduction of MBS.
Bottom line for Deutsche Bank’s Vessel: There are “more unknowns” about QT this time around.
Read more: Fed balance sheet projected to fall to $5.9 trillion by mid-2025
(Updated with comments from minutes of the Fed’s May policy meeting, starting in second paragraph.)
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