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Balance sheet runoff could put pressure on Treasury market, Fed staff say

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The Federal Reserve building is seen in Washington, US, January 26, 2022. Reuters/Joshua Roberts

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WASHINGTON, July 14 (Reuters) – Tension in the US Treasury market is reducing the central bank’s own balance sheets by increasing the impact of those cuts on financial markets and further raising interest rates, two new analyzes by Federal Reserve employees have concluded. can complicate planning. exceeded expectations.

The papers, by researchers at the Atlanta and Kansas City Fed regional banks, are similar to other efforts to predict how markets may be affected as the trillions of dollars of securities the Fed purchased to support the economy during the coronavirus pandemic are expected to mature. is allowed. “Roll off” its balance sheet.

But, in contrast to the relatively calm conditions that prevailed in 2017 when the Fed last lowered its balance sheet, this period of “quantitative tightening” (QT) was due to uncertainty about the economy, the Fed raising short-term interest rates and other factors. as factors. Major markets are tense for the US Treasury.

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Atlanta Fed researcher Bin Wei estimated that cutting the Fed’s holdings of US Treasury bonds by about $2.2 trillion over the next three years during “normal” times would have the same effect as an immediate increase of about 0.29 percent in the short-term federal funds policy rate. Will happen. score.

It’s a modest amount, and a figure similar to what Fed Chair Jerome Powell used when asked how the central bank’s balance sheet plans would further strengthen credit terms beyond any rate hikes planned by the Fed.

Yet in times of heightened volatility or stress in the Treasury market, he concluded, it would take a punch of about three typical rate hikes, or about 0.74 percentage points — a heavy blow that could tighten monetary policy more than the Fed expected. Is.

Balance sheet cuts began in June, and while they would add up to $95 billion each month, the first weeks saw the Fed’s $8.9 trillion in stock treasuries and mortgage-backed securities (MBS) drop by only $40 billion.

Still, analysts outside the Fed have already begun to link recent tensions in the Treasury market — ranging from high volatility to a bid-ask spread — to a potential trouble for the US central bank and cuts to its balance sheet. initial end.

“We would not say that the Treasury market is stressed,” Piper Sandler analysts Roberto Perli and Benson Durham wrote last week. “But poor liquidity conditions undoubtedly exacerbate pre-existing volatility. They may also prompt the Fed, which cares deeply about the functioning of the Treasury market, to stop QT sooner than it thinks at the moment. for.”

The Fed hasn’t specified a stopping point — the required size of its balance sheet in normal times depends on things like public demand for cash and the bank’s demand for Fed-held reserves. But analysts have pointed to a potential run-off of $2 trillion to $3 trillion in Treasury and MBS’ own holdings.

uncertain market conditions

In a separate paper, Kansas City Fed economists Rajdeep Sengupta and A. Lee Smith drew a contrast with the currently volatile state of markets and the calm conditions prevailing in 2017, when the Fed decided to buy securities after the 2007-2009 financial crisis. was allowed. to mature and fall from the books of the central bank.

The economy was still enjoying what would become a record-long expansion, and markets functioned smoothly as the Fed allowed its holdings to drop by $50 billion monthly. But even a relatively benign period of QT ended abruptly when the bank raised lending rates overnight in 2019, a sign the Fed had gone too far after a nearly $650 billion run-off.

This time the pace of cuts will be nearly twice as fast, and ambitions range from $2 trillion to $3 trillion in total.

The Kansas researchers noted that some of the Treasury’s major clients, such as pension funds and mutual funds, already have record-high volumes and that the government may have “limited ability to absorb new bonds” to repay the Fed. . Given the current geopolitical tensions in the world, foreign demand may also be limited.

The opposite can happen, of course: Times of tension sometimes have the effect of pulling capital for the United States looking for a safe haven, which is currently on a dynamic from declining U.S. Treasury yields and a stronger dollar. Example is.

But the uncertainty, by any measure, is greater, and greater risk than when the Fed trimmed its balance sheet before the pandemic. If buyers become scarce on margin for US debt, that would mean higher than expected interest rates.

Sengupta and Smith wrote, “The contrast between the volatile market conditions currently in place and the calm conditions prevailing in 2017 suggest that this QT episode is likely to be more disruptive than the benign start to the 2017 runoff.”

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Reporting by Howard Schneider; Editing by Paul Simao

Our Standards: Thomson Reuters Trust Principles.

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