The Federal Reserve’s faster exit from crisis-era policies will put additional strain on the $24 trillion US Treasury bond market and heighten concerns about the fundamentals of the global financial system.
The ease with which traders can close trades in the Treasury market has fallen to its lowest level since the pandemic began in March 2020, according to a Bloomberg index. The gaps between the prices at which traders buy and sell have widened, and huge price movements on a scale unthinkable a year ago have become commonplace.
The Fed this month is accelerating the unwinding of the nearly $9 trillion balance sheet it has built up over more than a decade to cushion the economy from shocks. It aims to shrink the total by $95 billion a month — twice the rate of August.
As a result, “we could have a liquidity 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 others [funding] markets.”
Bank of America has described tensions in the Treasury market as “probably . . . one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007.”
Two recent precedents are emerging: the 2019 crisis in the short-term credit market, known as a repo, and the 2020 collapse of the treasury market Borrow high-quality collateral such as government bonds. Then, in March 2020, the Treasury market stalled as companies rushed to get cash, in part by selling US Treasuries. Both cases threatened pillars of the global financial system and called in 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 symposium in Jackson Hole was presented.
The widely circulated paper, co-authored with former Reserve Bank of India Governor Raghuram Rajan, focused on how quantitative tightening and easing is affecting market liquidity. In the 2019 and 2020 crises, QT was “likely the deeper cause that left the system vulnerable,” they wrote.
They argued that central bank asset purchases, known as quantitative easing, stimulated the growth of bank deposits and lines of credit. The reversal will not result in banks reining in those obligations, even if it sucks cash out of the financial system, the paper said.
Instead, there is a risk that, in a moment of stress, all market participants will rush to take out short-term funding — for example, lines of credit — when there isn’t enough.
The paper “reflects our long-held fears that quantitative tightening could have more impact than central banks are going to admit,” said Michael Howell, CEO of CrossBorder Capital, a London-based research and investment firm.
Even the Fed has admitted they are unsure of the impact QT will have. “I want to emphasize how uncertain the impact of a balance sheet contraction is,” Fed Chair Jay Powell said after the May central bank meeting, though he later said that “by all accounts markets should be able to absorb it “.
The Treasury market, plagued by long-standing structural flaws and uncertainty over the Fed’s tightening trajectory, is facing some of the most choppy trading conditions in years. A measure of depth of market calculated by JPMorgan, which looks at two-, five-, 10- and 30-year Treasuries shows the worst liquidity since spring 2020. Selling prices – have reached the highest levels since May 2020 in recent months.
Poor liquidity has led to higher volatility. The Ice-BofA-Move index of Treasury market implied volatility is hovering near March 2020 levels, well above its long-term average.
QT could fuel the situation, analysts have warned. Right now, when the bonds held by the Fed are maturing, the central bank is pouring the money back into the market. When it stops, investment banks — known as dealers — will have to mop up 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 courage to do so.
“Traders will inevitably hold more treasury inventory. They will need to fund what is putting upward pressure on repo rates, which over time will likely contribute to more volatile Treasury markets and potentially worsening Treasury liquidity,” said Mark Cabana, head of US rates strategy at the Bank of America.
At the extreme, a Treasury market struggling to absorb additional inventory could result in a “cascading” effect, said Scott Skyrm, repo trader at Curvature Securities. As supply floods the market, Treasury buyers may back down in anticipation of better prices in the future. Potential turning points could come at the end of the quarter or year-end, when banks pull out of the funding markets to shore up balance sheets for reporting dates.
Cabana and Skyrm agreed that a 2019-style congestion in the repo market was not a major concern. Skyrm pointed to the $2.2 trillion pile of cash in the Fed’s reverse repo facility (RRP), a loophole where investors earn a bit of interest on money that has no better purpose. The EIA was still hardly used in 2021.
“I do not understand [a repo blow-up] as a risk to the financial system until the EIA drops to zero,” Skyrm said.
Fed officials have provided rough estimates of the impact of QT, including Vice Chair Lael Brainard’s assessment that rate hikes will be two or three quarter points. Recent research published by Fed officials came to similar conclusions.
Some investors are relaxed, partly because they expect the Fed to actively avoid cracks. QT doesn’t create systemic risk “because the Fed controls it and the Fed will never allow it to be systemic,” said Tiffany Wilding, economist at Pimco.
However, other investors welcomed the possibility of QT cutting risky assets from levels they view as unsustainable.
“‘Systemic liquidity shock’ is a fancy way of saying ‘panic,’ and panic is what markets do,” said Dan Zwirn, chief executive at Arena Investors, a private lending firm. “This is how asset bubbles are corrected. This creates institutional memory that delays the next bubble. Otherwise you are systematically misjudging the risk.”