A look at past episodes that caused the Fed to alter its policy trajectory or take emergency measures reveals that disruptions in the smooth functioning of money markets and the US government debt market were the main triggers. Concern about these markets, critical to the stability of the financial system, will only grow as the Fed begins in weeks to withdraw liquidity from the markets by reducing its balance sheet by $8.9 trillion.
The problem is that what was once a rare occurrence is becoming more and more common. In 2019, the repurchase deal market took hold after months of dwindling bank reserves as the Fed unwound its Treasury holdings. Then, in March 2020, as the pandemic sent panicked businesses, consumers and investors into a frantic race for cash, liquidity in the then $17 trillion market for Treasuries suddenly disappeared. . The Fed responded with unlimited bond purchases that did not stop until this year. The Treasury market has since reached $23 trillion.
Starting next month, the Fed will begin to reduce its bond holdings, which consist almost exclusively of Treasuries and mortgage-backed securities. Although policymakers hope the cut will not disrupt market functioning, it will be accompanied by what is expected to be an aggressive interest rate hike at the next two central bank policy meetings to rein in runaway inflation. .
The risks are now higher given the Fed’s significant presence in the bond market and the exponential growth of its role as a so-called liquidity provider, with its balance sheet having more than doubled since late 2019. Moreover, the Fed isn’t the only one pulling back. The European Central Bank, Bank of England and Reserve Bank of Australia are also entering into quantitative easing programs. During the Fed’s balance sheet run-off in 2017-2019, the ECB was still buying bonds.
Two things can go wrong when the Fed starts shrinking its bond portfolio. The first is that it must also balance its liabilities, part of which are bank reserves. Although these are plentiful today, banks must constantly build up enough reserves to meet increasingly stringent regulatory requirements. But even when these reserves are sufficient, they are not evenly distributed among lenders. It was this imbalance that caused the repo market to seize in 2019. Assuming the Fed’s balance sheet shrinks by about $500 billion this year, bank reserves could shrink by about $1 trillion. by the end of the year, compared to around $3.3 trillion currently, according to Barclays Capital. market strategist Joseph Abate.
Just three months before repo rates climbed into double digits in September 2019, Fed officials were reassuring investors that reserves were plentiful and balance sheet reduction would continue to operate on autopilot. Then, on September 17, repo rates soared to 10%, forcing the Fed to reverse course, prematurely end balance sheet runoff and buy Treasuries. At the time, some rate strategists even suggested that the Fed should initiate some sort of permanent quantitative easing to manage market liquidity.
The Treasury market would not be immune to dislocations. The Fed’s purchases have helped improve liquidity in an unloved segment of the market: so-called off-the-run Treasuries, which are no longer the benchmark maturities.
It’s not that the Fed hasn’t learned its lessons. There is now a permanent repurchase facility to meet emergency cash flow needs and help mitigate potential dislocations. And the Fed has taken a cautious approach to shrinking its balance sheet this time around, largely due to the troubled experience of 2019. Fed Chairman Jerome Powell has vowed to slow down or to stop the decline in the balance sheet before the reserves fall below the levels. considered “sufficient”.
But what these levels are and how quickly they would decrease, anyone can guess. By its own admission, the Fed isn’t sure how its actions will impact liquidity or how the untested standing repo facility will be used. “I can’t tell you how it will actually work,” Federal Reserve Bank of Chicago President Charles Evans told Bloomberg News on May 18.
What is certain is that once the Fed begins to reduce its balance sheet while continuing to raise rates in successive half-point hikes this summer, there will be unprecedented tightening. If the backbone of the financial system begins to crack, expect the Fed to change course.
More other writers at Bloomberg Opinion:
Liquidity could be the next crisis to hit the markets: Jared Dillian Stock selling could enter a new phase: Mohamed A. El-Erian Profits go from savior to stock enemy: Jonathan Levin
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Jenny Paris is Bloomberg News’ Senior Editor for Global Bonds, Currencies and Emerging Markets. She previously worked at the Wall Street Journal and Dow Jones Newswires covering the Eurozone crisis and as an editor for Asian equity markets.
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