The Fed’s faster “quantitative tightening” increases the strain on the bond market

The Federal Reserve’s faster exit from crisis-era policies will strain the US $ 24 trillion government bond market, increasing concerns about the global financial system.

The ease with which traders can close deals in the Treasury market has fallen to its lowest levels since the early days of the pandemic in March 2020, according to a Bloomberg index. The price gaps in which traders buy and sell have widened and huge price movements, on a scale unthinkable even just a year ago, have become commonplace.

The Fed this month is accelerating the nearly $ 9 trillion balance sheet liquidation pace it has accumulated for more than a decade in an effort to cushion the economy from shocks. It aims to reduce the total by $ 95 billion per month, double the pace in August.

As a result, “we may have a liquidity stress problem in the banking system,” said NYU economist Viral Acharya. “And whenever banks are under stress, it usually spreads to non-bank and Treasury and other markets [funding] markets “.

Bank of America has described the Treasury market tensions as “probably… One of the biggest threats to global financial stability today, potentially worse than the 2004-2007 housing bubble.”

Two recent precedents loom: the 2019 crisis in the short-term loan market, known as repo, and the 2020 Treasury market crash. In the first episode, the night market in which banks lend cash to other institutions in exchange for High quality collateral like Treasuries has crashed. Then, in March 2020, the Treasury market swelled as companies rushed to get cash, partly by selling US government bonds. Both cases endangered the pillars of the global financial system, luring the Fed to stop the rot.

Both episodes also reflected the impact of the Fed’s move 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 Fed’s recent annual Jackson Hole symposium.

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

They said the central bank’s asset purchase, known as quantitative easing, stimulates the growth of bank deposits and lines of credit. Reversing does not lead banks to hold back such commitments, even if it sucks money out of the financial system, the paper said.

Instead, the risk is that, in a time of stress, all market participants rush to apply for short-term financing, for example by taking advantage of lines of credit, when there is not enough to spend.

The paper “echoes our longstanding fears that quantitative tightening may have more effects than central banks will confess,” said Michael Howell, chief executive officer of CrossBorder Capital, a London-based research and investment house.

Even the Fed admitted that it is unsure what QT’s impact will be. “I would like to emphasize how uncertain the effect of the balance sheet contraction is,” Fed Chairman Jay Powell said after the central bank’s May meeting, although he later said that “according to all assessments, markets should be in able to absorb this “.

The Treasury market, which suffers from long-standing structural flaws, as well as uncertainty about the path to follow for the Fed’s monetary tightening, is facing some of the most volatile trading conditions in recent years. A measure of market depth calculated by JPMorgan looking at two-, five-, 10-, and 30-year Treasuries shows the worst liquidity since spring 2020. Bid-ask spreads: A liquidity measure that captures the gap between buy and sell prices : in recent months they have reached the widest levels since May 2020.

Poor liquidity meant increased volatility. The Ice-BofA Move index of Treasury market implied volatility is approaching March 2020 levels, well above its long-term average.

QT could inflame the situation, analysts warn. At this time, when the bonds held by the Fed mature, the central bank puts the money back into the market. When it stops, investment banks – known as dealers – must collect the excess card in the system as well as any new bonds issued by the US Treasury. The commercial sector doesn’t necessarily have the stomach for it.

“Dealers will inevitably hold more Treasury stock. They will have to finance it, which puts 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 US rate strategy at Bank of America.

In 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 could retreat in the expectation of better prices in the future. Potential breaking points could come at the end of the quarter or year as banks pull out of funding markets to improve balance sheets for reporting deadlines.

Percentage line chart (daily) showing the repo rate, which usually tracks the federal funds rate, can increase during crises

Cabana and Skyrm agreed that a 2019-style clog in the repo market was not a primary concern. Skyrm pointed to the $ 2.2 trillion stack of cash located at the Fed’s reverse-repo (RRP) facility, a screw hole where investors earn some interest on money that has no use. improve. The MSRP was barely used recently in 2021.

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

Fed officials offered rough estimates of QT’s impacts, including Vice President Lael Brainard’s assessment that it will be equivalent to a two- to three-quarter point increase in interest rates. Recent research published by Fed staff reached similar conclusions.

Some investors are calm, in part because they assume the Fed will actively avoid any crack. The QT does not create systemic risk “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 welcomed the possibility of QT dropping risk assets from levels they consider unsustainable.

“‘Systemic liquidity shock’ is an elegant way of saying ‘panic’, and panic is what the markets do,” said Dan Zwirn, chief executive officer of Arena Investors, a private lending firm. “This is how asset bubbles are corrected. This is how institutional memory occurs, delaying the occurrence of the next bubble. Otherwise, you systematically risk devaluing the price.

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