By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) – The U.S. Federal Reserve’s ongoing balance sheet drawdown has exacerbated low liquidity and high volatility in the $20-trillion U.S. Treasury debt market, raising questions on whether the Fed needs to re-think this strategy.
Intended to drain stimulus pumped into the economy during the COVID-19 pandemic, the Fed’s quantitative tightening (QT), as it is commonly referred to, has been running for the last five months. The Fed’s balance sheet though remains at a lofty $8.7 trillion, down modestly from a peak of nearly $9 trillion.
Since September, the Fed has planned to allow $95 billion in balance sheet runoff, meaning it would no longer reinvest the principal and interest payments received from maturing U.S. Treasuries and mortgage-backed securities.
However, there are underlying liquidity and volatility problems in U.S. Treasuries amid the Fed’s aggressive rate hike cycle. The problems can also be traced to long-running structural issues arising from U.S. banking regulations created in the aftermath of the 2008 global financial crisis.
While the Fed is determined to reduce its balance sheet, if the problems facing investors get out of control, some analysts said the Fed may just halt or suspend it.
“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,” wrote Ryan Swift, BCA Research U.S. bond strategist in a research note.
UBS economists said last month the Fed’s balance sheet runoff will face several complications through 2023, prompting the Fed to sharply slow or fully stop balance sheet reduction sometime around June 2023.
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.
“There is some sort of indirect function that QT is exacerbating that lack of liquidity,” said Adam Abbas, portfolio manager and co-head of fixed income at asset manager Harris Associates, which oversees $86 billion in assets. “There’s a derivative effect when you have such a large buyer – we’re talking about 40% of the marketplace – not only step out but become a net seller.”
WIDER BID-ASK SPREADS
The low liquidity has heightened volatility in the Treasury market and widened bid-ask spreads, market participants said, meaning participants pay marginally more to buy and get less to sell a security than they used to
The ICE BofA MOVE Index <.move>, a gauge of expected volatility in U.S. Treasuries, was at 128.44 last Friday. That level indicates that the bond market expects Treasuries to move by an average of eight basis points over the next month, analysts said. Over the last decade, the average move in Treasuries was about two to three basis points.
To be sure, the Treasury market’s liquidity issues have been bubbling under the surface for years, tied to financial sector regulations created following the global financial crisis.
BCA’s Swift said while the Treasury market has grown dramatically since 2008, dealer intermediation, has remained low, noting that regulations made it less appealing for dealers to undertake such activity in the Treasury market.
Dealers typically support market liquidity by intermediating customer trades – for example, by taking customer sell orders into inventory when buyers are absent.
The Fed, however, cannot do anything to resolve the intermediation issue. It can only step in the market and purchase bonds when the market becomes untethered from fundamentals like what happened during the pandemic, analysts said, which could mean halting QE.
For now, very few market participants envision the Fed ending or pausing QT, as a significant component of inflation could be attributed to liquidity that came from quantitative easing (QE) during the pandemic era.
“If you accept that some of that $5 trillion (QE) is driving some of the current inflation, then the solution to the inflation problem must include shrinking the balance sheet,” said Scott Skyrm, executive vice president at Curvature Securities.
“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.”
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Josie Kao)
