Analysis-Nagging U.S. Treasury liquidity problems raise Fed balance sheet predicament By Reuters


© Reuters. FILE PHOTO: The U.S. Federal Reserve constructing is pictured in Washington, March 18, 2008. REUTERS/Jason Reed/File Photograph

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – The U.S. Federal Reserve’s ongoing steadiness sheet drawdown has exacerbated low liquidity and excessive volatility within the $20-trillion U.S. Treasury debt market, elevating questions on whether or not the Fed must re-think this technique.

Supposed to empty stimulus pumped into the economic system in the course of the COVID-19 pandemic, the Fed’s quantitative tightening (QT), as it’s generally referred to, has been operating for the final 5 months. The Fed’s steadiness sheet although stays at a lofty $8.7 trillion, down modestly from a peak of almost $9 trillion.

Since September, the Fed has deliberate to permit $95 billion in steadiness sheet runoff, that means it could not reinvest the principal and curiosity funds obtained from maturing U.S. Treasuries and mortgage-backed securities.

Nevertheless, there are underlying liquidity and volatility issues in U.S. Treasuries amid the Fed’s aggressive charge hike cycle. The issues may also be traced to long-running structural points arising from U.S. banking laws created within the aftermath of the 2008 international monetary disaster.

Whereas the Fed is set to scale back its steadiness sheet, if the issues dealing with traders get uncontrolled, some analysts mentioned the Fed could halt or droop it.

“It’s definitely conceivable that, if bond volatility continues to rise, we might see a repeat of March 2020. The Fed will likely be pressured to finish its QT and purchase a considerable amount of Treasury securities,” wrote Ryan Swift, BCA Analysis U.S. bond strategist in a analysis word.

UBS economists mentioned final month the Fed’s steadiness sheet runoff will face a number of problems by 2023, prompting the Fed to sharply sluggish or absolutely cease steadiness sheet discount someday round June 2023.

A key indicator that traders monitor is the liquidity premium of on-the-run Treasuries, or new points, in contrast with off-the-runs, that are older Treasuries representing nearly all of complete excellent debt, however make up solely about 25% of each day buying and selling quantity.

On-the-run Treasuries usually command a premium over off-the-runs in instances of market stress. BCA Analysis information confirmed that 10-year on-the-run premiums over their off-the-run counterpart are at their widest since no less than 2015.

Morgan Stanley (NYSE:) in a analysis word mentioned that off-the-run liquidity is most impaired in U.S. 10-year notes, adopted by 20-year and 30-year bonds, in addition to five-year notes.

“There may be some kind of oblique operate that QT is exacerbating that lack of liquidity,” mentioned Adam Abbas, portfolio supervisor and co-head of fastened earnings at asset supervisor Harris Associates, which oversees $86 billion in property. “There is a spinoff impact when you’ve gotten such a big purchaser – we’re speaking about 40% of {the marketplace} – not solely step out however turn into a internet vendor.”


The low liquidity has heightened volatility within the Treasury market and widened bid-ask spreads, market contributors mentioned, that means contributors pay marginally extra to purchase and get much less to promote a safety than they used to

The ICE (NYSE:) BofA MOVE Index (), a gauge of anticipated volatility in U.S. Treasuries, was at 128.44 final Friday. That stage signifies that the bond market expects Treasuries to maneuver by a median of eight foundation factors over the subsequent month, analysts mentioned. Over the past decade, the typical transfer in Treasuries was about two to 3 foundation factors.

To make sure, the Treasury market’s liquidity points have been effervescent underneath the floor for years, tied to monetary sector laws created following the worldwide monetary disaster.

BCA’s Swift mentioned whereas the Treasury market has grown dramatically since 2008, vendor intermediation, has remained low, noting that laws made it much less interesting for sellers to undertake such exercise within the Treasury market.

Sellers usually assist market liquidity by intermediating buyer trades – for instance, by taking buyer promote orders into stock when patrons are absent.

The Fed, nonetheless, can’t do something to resolve the intermediation challenge. It could possibly solely step available in the market and buy bonds when the market turns into untethered from fundamentals like what occurred in the course of the pandemic, analysts mentioned, which might imply halting QE.

For now, only a few market contributors envision the Fed ending or pausing QT, as a significant factor of inflation may very well be attributed to liquidity that got here from quantitative easing (QE) in the course of the pandemic period.

“In the event you settle for that a few of that $5 trillion (QE) is driving a few of the present inflation, then the answer to the inflation drawback should embrace shrinking the steadiness sheet,” mentioned Scott Skyrm, government vp at Curvature Securities.

“Therein lies the dilemma. If the Fed runs down the SOMA (system open market account) portfolio an excessive amount of, they may break one thing available in the market. If they do not, we’re caught with inflation.”

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