Interest rate hikes get most of the attention as they The Federal Reserve Fights Inflation, but arguably the balance sheet reduction is more important. And it’s not going well.
Since the Fed stopped buying Treasuries and began letting the bonds fall off its books as they matured, the bond market has experienced increasing volatility and liquidity problems. In fact, there is already talk of the possibility of the central bank abandoning quantitative tightening.
Since the Fed launched its first quantitative easing (QE) program in the aftermath of the 2008 financial crisis, it has purchased more than $8 trillion in US Treasury bonds and mortgage-backed securities.
In effect, the Federal Reserve monetized trillions of dollars in government debt, first in the aftermath of 2008 and then again during the pandemic. Through various QE programs, the Fed bought bonds with money created out of thin air, creating an artificial demand for Treasuries. Central bank bond buying keeps the price high and keeps bond yields artificially low. This allows the US government to sell more bonds than it could without Fed intervention. Without the Federal Reserve’s big thumb in the bond market, Uncle Sam would find it difficult to maintain his borrowing policies and spent. Interest rates would rise too high to make further borrowing sustainable.
That is starting to happen today.
When the Fed started quantitative tightening, the artificial demand it created disappeared. As a result, bond prices plummeted and interest rates skyrocketed. This is not a good scenario for a US government with over $31 trillion in debt.
As the Fed runs QE, the new money it creates to buy bonds finds its way into the economy. This is the inflation definition. The only way the Federal Reserve can address inflation is to stop creating money and remove the excess it created from the economy. Quantitative adjustment (QT) is a key part of this process. If the Fed were really serious about fighting inflation, it would not only allow maturing bonds to be removed from its balance sheet, it would also sell Treasuries on the open market. This would reduce the balance sheet of the Federal Reserve and take excess dollars out of the economy. But central bankers know they can’t do that without crashing the Treasury market.
In May, the Fed announced a QT program when the CPI began to rise. Under the plan, the Fed is supposed to reduce the balance sheet by $95 billion a month. This is an increase from $47.5 billion before September. Under the Federal Reserve’s plan, it would take the central bank more than seven years to reduce the balance sheet to pre-pandemic levels. Y it is even below that target. To date, the Fed has only met or exceeded its target once (August) in six months.
But even this tepid QT program is causing trouble in the Treasury market.
According to a recent Reuters report“The current US Federal Reserve balance sheet drawdown has exacerbated low liquidity and high volatility in the $20 trillion US Treasury debt market, raising questions about whether the Fed needs to rethink this strategy”.
A bond analyst said Reuters that volatility could force the Fed to return to QE.
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 lot of Treasuries.”
UBS economists said the Fed could be forced to end QT in mid-2023.
This is not good news for those who expect the Fed to win the fight against inflation. A return to QE literally means a return to inflation.
Reuters explained the liquidity problem.
A key indicator that investors track is the liquidity premium on current, or new, Treasury bonds, compared to off-terms, which are older Treasury bonds that account for the majority of total outstanding debt, but they represent only about 25% of the debt. daily trading volume. Treasuries that are going are often at a premium over those that are not going in times of market stress. Data from BCA Research showed that 10-year premiums on the fly over its non-flying counterpart are at their broadest level since at least 2015. Morgan Stanley in a research note said off-fly liquidity is more US impaired 10-year notes, followed by 20- and 30-year bonds, as well as five-year notes.”
The only thing the Fed can do to alleviate the problem is to buy bonds again. If the market starts to crash, that is almost certainly the path it will take.
Again, and I cannot stress this enough, the Fed cannot fight inflation and simultaneously execute quantitative easing.
One analyst summed up the conundrum facing the Federal Reserve.
Therein lies the dilemma. If the Fed depletes the SOMA (system open market account) portfolio too much, it will break something in the market. If they don’t, we’re stuck in inflation.”
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