Fed’s faster ‘quantitative tightening’ adds pressure on bond market

The Federal Reserve’s quicker exit from policy amid the crisis is expected to put the $24 billion U.S. government bond market under additional pressure, heightening concerns about the foundation of the global financial system.

The ease with which traders can complete transactions in the Treasury market has fallen to the lowest levels since the early days of the pandemic in March 2020, according to a Bloomberg index. The gaps between prices where traders are buying and selling have widened and huge price movements, on a scale unthinkable even a year ago, have become commonplace.

The Fed is this month accelerating the pace of liquidation of the nearly $9 billion balance sheet it has built up over more than a decade in an effort to cushion the economy from shocks. It aims to cut the total by $95 billion a month, double the pace in August.

As a result, “we could have a liquidity stress problem in the banking system,” said New York University economist Viral Acharya. “And whenever banks are stressed, it usually spreads to non-bank and treasury markets and other [funding] markets”.

Bank of America described the tensions in the Treasury market as “no doubt. . . one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007.

Two recent precedents loom large: the 2019 crisis in the short-term loan market, known as repo, and the 2020 Treasury market crash. In the first episode, the overnight market where banks lend money to other institutions in exchange for high-quality collateral like frozen treasury bills. Then, in March 2020, the Treasury market bogged down as companies scrambled for cash, in part by selling US government bonds. Both cases jeopardized the pillars of the global financial system, calling on the Fed to stop the rot.

Both episodes also reflected the impact of the Fed’s decision to reduce the size of its balance sheet – a process known as quantitative tightening – according to a paper presented by Acharya and several co-authors at the recent annual symposium of the Fed in Jackson Hole.

The widely circulated paper, co-authored with former Reserve Bank of India Governor Raghuram Rajan, focused on how quantitative tightening and easing affect market liquidity. During the crises of 2019 and 2020, QT “was probably the deepest cause that made the system vulnerable,” they wrote.

They argued that the central bank’s purchase of assets, known as quantitative easing, stimulates the growth of bank deposits and lines of credit. Reversing it does not lead banks to curb these commitments, even if it sucks money from the financial system, according to the newspaper.

Instead, the risk is that, in a moment of stress, market participants all rush to claim short-term funding – for example by tapping lines of credit – when there is not enough to cover. everybody.

The document “echoes our long-standing fears that quantitative tightening could have more effect than central banks are letting on,” said Michael Howell, managing director of CrossBorder Capital, a research and investment firm. based in London.

Even the Fed admitted that it didn’t know what the impact of QT would be. “I would emphasize how uncertain the effect of balance sheet reduction is,” Fed Chairman Jay Powell said after the central bank’s May meeting, though he later said that “according to all valuations, markets should be able to absorb that.”

The Treasury market, suffering from long-standing structural flaws, as well as uncertainty over the path ahead for Fed monetary tightening, is facing some of the most choppy trading conditions in years. A measure of market depth calculated by JPMorgan that looks at two-, five-, 10- and 30-year Treasury bills shows the worst liquidity since the spring of 2020. Bid-ask spreads – a measure of liquidity that captures the spread between the purchase and sale price — have reached the highest levels since May 2020 in recent months.

Low liquidity translated into higher volatility. The Ice-BofA Move index of implied Treasury market volatility is hovering near March 2020 levels, well above its long-term average.

QT could escalate the situation, analysts have warned. Currently, when bonds held by the Fed mature, the central bank returns the money to the market. When it stops doing so, investment banks — known as brokers — must mop up any excess paper in the system in addition to any new bonds issued by the US Treasury. It is not certain that the commercial sector has the stomach for this.

“Dealers will inevitably hold more Treasury inventory. They’re going to have to fund that, putting upward pressure on repo rates, which over time will likely contribute to more volatile Treasury markets, potentially worsening Treasury liquidity,” said Mark Cabana, head of U.S. rates strategy at Bank of America.

At the extreme, a Treasury market struggling to absorb additional inventory could lead to a “cascade” effect, said Scott Skyrm, a repo trader at Curvature Securities. With supply flooding the market, Treasury buyers may pull back in expectation of better pricing in the future. Potential breaking points could come at the end of the quarter or year, as banks withdraw from the funding markets to improve their balance sheets in line with reporting deadlines.

Percent line chart (daily) showing that the repo rate, which typically tracks the fed funds rate, can skyrocket during crises

Cabana and Skyrm agreed that a 2019-style bottleneck in the repo market was not a primary concern. Skyrm pointed to the $2.2 billion pile of cash that sits in the Fed’s reverse repurchase facility (RRP), a bolthole where investors earn some interest on cash which has no better use. The RRP was barely used as recently as 2021.

“I do not see [a repo blow-up] as a risk to the financial system until the RRP is reduced to zero,” Skyrm said.

Fed officials have offered rough estimates of QT’s impacts, including Vice Chairman Lael Brainard’s assessment that it will equate to a two- or three-quarter point increase in interest rates. Recent research published by Fed staffers came to similar conclusions.

Some investors are relaxed, partly because they assume the Fed will actively avoid any cracks. QT does not create systemic risks “because the Fed controls it and the Fed will never allow it to be systemic,” said Tiffany Wilding, an economist at Pimco.

But other investors have welcomed the possibility that QT will knock risk assets down from levels they see as unsustainable.

“‘Systemic liquidity shock’ is a fancy way of saying ‘panic’, and the markets are panicking,” said Dan Zwirn, managing director of Arena Investors, a private lending firm. “This is how asset bubbles are corrected. This is how institutional memory occurs, delaying the onset of the next bubble. Otherwise, you are systematically assessing the risk wrongly.

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