Interest rate hikes get most of the attention as the Federal Reserve fights pumpiing , but balance page reduction is arguably essential. And it’s not going well.
Since the Given stopped buying Treasuries plus started letting bonds fall off its books because they mature, the bond marketplace has experienced increasing volatility and liquidity problems. In fact , there is already talk about associated with the central bank leaving quantitative tightening.
Since the Fed launched the first quantitative easing (QE) program in the wake of the 08 financial crisis, it has purchased greater than $8 trillion in US Treasury bonds and mortgage-backed securities.
In effect, the Fed monetized trillions of dollars in govt debt, first in the wake of ’08 and then again throughout the pandemic. Through various QE programs, the Fed purchased bonds with money developed out of thin air, creating a good artificial demand for Treasuries. Central bank bond buying holds the price up and keeps bond yields synthetically low. This allows the US government to sell more bonds than it could with no Fed’s intervention. Without the Fed’s big fat thumb for the bond market, Uncle Sam would have a hard time maintaining its borrow and spend policies. Rates of interest would rise too high for making further borrowing tenable.
That’s beginning to take place today.
Once the Fed started quantitative tensing, the artificial demand it created disappeared. As a result, relationship prices tanked and interest rates spiked. This is not a good scenario for a US government with more than $31 trillion in debt .
As the Fed runs QE, the new money that it generates to buy bonds finds the way into the economy. This is the definition of inflation . The only way the Fed can tackle inflation is to stop creating money plus remove the excess it made from the economy. Quantitative tightening (QT) is a key part of this process. If the Fed really was serious about fighting inflation, it might not only let maturing provides roll off its stability sheet, but it would furthermore sell Treasuries into the open market. This would shrink the Fed balance sheet and pull excess dollars from the economy. But the central bankers know they can’t do that without having collapsing the Treasury marketplace.
In May, the Fed announced a QT program as CPI began to climb. According to the plan, the particular Fed is supposed to be decreasing the balance sheet by $95 billion a month. This is up from $47. 5 billion before September. Based on the Given plan, it would take over seven years for the central financial institution to reduce the balance sheet in order to prepandemic levels. And it’s even falling lacking that goal . To date, the Fed has only succeeded in meeting or exceeding its goal 1 time (August) in six months.
But even this tepid QT program is certainly causing problems in the Treasury market.
In accordance to a recent Reuters report , “ The US Federal Reserve’s ongoing stability sheet drawdown has amplified low liquidity and high volatility in the $20-trillion US Treasury debt market, increasing questions on whether the Given needs to re-think this strategy. ”
One relationship analyst told Reuters that the volatility could force the Fed to pivot back to QE.
“ It is certainly conceivable that, in the event that bond volatility continues to increase, we could see a repeat of March 2020. The Given will be forced to end the QT and buy a large amount of Treasury securities. ”
UBS economists said the Fed may be forced to end QT by the middle of 2023.
This is not good news for those expecting the Fed to earn the inflation fight. Going back to QE literally indicates a return to inflation.
Reuters explained the liquidity problem.
“ A key indicator that investors track is the liquidity premium of on-the-run Treasuries, or new issues, compared to off-the-runs, which are older Treasuries representing the majority of total excellent debt, but make up only about 25% of daily trading volume. On-the-run Treasuries usually command a premium over off-the-runs in times of market stress. BCA Research data showed that will 10-year on-the-run premiums more than their off-the-run counterpart are at their widest since a minimum of 2015. Morgan Stanley in the 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. ”
The only thing the Fed can do to alleviate the problem is to return to buying bonds. If the marketplace starts to collapse, that’s almost certainly the path it will take.
Again, and I can’t stress this enough, the Given can’t simultaneously fight inflation and run quantitative reducing.
One expert summed up the conundrum dealing with the Fed.
“ Therein lies the dilemma. If the Given runs down the SOMA (system open market account) profile too much, they will break some thing in the market. If they don’t, we have been stuck with inflation. ”