Treasury Market Faces Liquidity Risks As Fed Pares Balance Sheet

With the Federal Reserve set to begin letting bonds mature off its $9 trillion balance sheet, the key metric to watch will be whether Treasury volatility picks up as a result in a market already suffering bouts of low liquidity.

The Fed's so-called quantitative tightening (QT) could also send yields higher, though analysts say this will depend on the direction of the economy, among other factors.

The Fed will let bonds mature off its balance sheet without replacement starting June 1 as it attempts to normalize policy and bring down soaring inflation. This follows unprecedented bond purchases from March 2020 to March 2022, meant to blunt the economic impact of business closures during the pandemic.

But as the world's largest holder of U.S. government debt reduces its presence in the market, some worry the absence of its dampening effect as a consistent, price-insensitive buyer could worsen market conditions.

"The impact of QT will be more evident in places like money markets and in market functioning as opposed to yield levels and curves," said Jonathan Cohn, head of rates trading strategy at Credit Suisse in New York, adding that he will be watching "the way in which it proceeds through deposits, through the withdrawal of liquidity and through the added burden that it places on dealers."

The Fed is pulling back at a time when the Treasury market was already struggling with periods of choppy trading. U.S. government debt issuance has soared while banks face greater regulatory constraints, which they say has impeded their ability to intermediate trading.

"On the margin we could see a little bit weaker liquidity in the Treasury market because there's no opportunity to sell bonds from dealer balance sheets on to the Fed," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia. "That might increase volatility, but liquidity is also already pretty thin within the rates space and that's not necessarily directional."

Banks have reduced bond purchases this year. Some hedge funds have also reduced their presence after being burned by losses during bouts of volatility. Foreign investors have also shown less interest in U.S. debt as hedging costs rise and as an increase in foreign bond yields offers more options.

To the degree that the Fed's retreat does impact yields, it will most likely be higher. Many analysts thought the Fed kept benchmark yields artificially low and contributed to a brief inversion of the Treasury yield curve in April.

"The risk is the market is unable to absorb the additional supply and you do have a big adjustment in valuations," said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities in New York. "We will still see more long-end supply than we did pre-COVID for quite some time, so all else being equal that should pressure rates a bit higher and the curve a bit steeper."

The direction of yields, however, will still be influenced by other factors, including expectations for the Fed's interest rate hikes and the economic outlook, which could override any impact from QT.

"From a top-down macro perspective we think other determinants will be just as or likely even more important for thinking about the direction of yields," said Credit Suisse's Cohn.

The last time the Fed reduced its balance sheet it ended badly. Rates to borrow in the crucial overnight repurchase agreement market surged in Sept. 2019, which analysts attributed to bank reserves falling too low as the Fed ran down its balance sheet from Oct. 2017.

That is less likely this time around after the Fed set up a standing repo facility that will function as a permanent backstop for the crucial funding market.

There is also significant excess liquidity in the form of bank reserves and cash lent into the Fed's reverse repurchase facility, which may take time to work through. Bank reserves stand at $3.62 trillion, up sharply from $1.70 trillion in Dec. 2019. Demand for the Fed's overnight reverse repo facility, where investors borrow Treasuries from the Fed overnight, set a record at more than $2 trillion last week.

The Fed is also taking time to ramp up to its monthly cap of $95 billion in bonds that it will allow to roll off its balance sheet each month. This will include $60 billion in Treasuries and $35 billion in mortgage-backed debt, and will fully take force in September. These caps will be $30 billion and $17.5 billion, respectively, until then.