VSCONSIDER THE life of a Treasury bill or bond. Typically, once or twice a week, a batch of fresh Treasuries are born. Their first home is usually, briefly, the trading desk of an investment bank. These brokers may keep a few for themselves, but they usually distribute the bulk to more permanent owners, such as the bond portfolios of a mutual fund, foreign government, or corporation. or the Federal Reserve. A certain slice will change hands several times – about $700 billion is traded every business day – but many will stay put for life. Their death is predetermined: they come of age, or “mature”, as little as one month or as long as 30 years after birth, at which time they are settled and cease to exist.
The Fed is the largest holder of Treasuries – its balance sheet is where many of these securities have found their permanent home. Thanks to bond-buying programs put in place to ease monetary conditions during the pandemic, the Fed now holds some $5.8 trillion in Treasuries, or a quarter of the $23.2 trillion issued by the Fed. government (see chart – it also holds $2.7 trillion worth of mortgage-backed securities). On May 4, however, Jerome Powell, the Fed’s chairman, said it would begin shrinking that giant portfolio, a process known as “quantitative tightening” (QT), in June. The reversal could trigger a repeat of the temporary but troubling blackouts that the world’s most important financial market has suffered in recent years, on a larger scale.
According to the policy statement released on May 4, the Fed will shrink its balance sheet not by actively selling, but by letting end-of-life bonds mature without buying a new note or bond to replace them. By September, if all went according to plan, the Fed’s portfolio will shrink by $95 billion a month, split between $60 billion in Treasuries and $35 billion in mortgage-backed bonds. . At this rate, the Fed’s balance sheet will shrink by more than $1 billion over the next year. It’s “quite the clip,” says Darrell Duffie of Stanford University.
There are two reasons why investors and policymakers are watching QT closely. The first is its potentially large impact on monetary policy. Estimates of the effect of buying bonds on the cost of money vary, but any downward pressure on interest rates exerted when the Fed bought Treasuries is likely to reverse. when his holdings begin to dwindle. Two-year Treasury yields have already risen to 2.7% from 0.8% in January 2022, as investors expect a faster balance sheet contraction and faster rate increases. On May 4, Powell announced a 50 basis point rate hike, the first hike of that size since 2000, and signaled that more would be “on the table at the next two meetings.”
It is also possible that QT will cause the Treasury market to malfunction, the second reason for concern. Its smooth operation matters well beyond America: Treasury rates are a crucial benchmark for pricing virtually every other financial asset in the world. And recent history is not encouraging. A series of episodes, including the 2014 “flash rally”; stress in the repo market (a key money market where treasury bills can be exchanged for cash) in September 2019; and the covid-19 shock of March 2020, during which the Treasury market actually ceased to operate for a time, created serious doubts about the strength of the Treasury market.
Each of the episodes had slightly different causes. Regardless of how robust the Treasury market was, there was little that would have stopped the extreme nature of the covid-19 shock from shaking it. The pension crisis was partly the result of some perverse incentives caused by post-crisis regulation that discouraged banks from holding treasury bills. But both have been exacerbated by a deeper problem, says Randal Quarles, a former vice chairman for oversight at the Fed, that the Treasury market “has grown beyond its waistline.”
A combination of financial crisis stimulus, budget deficits under President Trump, and pandemic-era splurges have caused the Treasury market to nearly quintuple since 2007. At the same time, new regulations imposed on banks investment markets, which are the main conduits of Treasury markets, such as the introduction of the additional leverage ratio, which measures the total size of bank assets relative to the amount of capital they hold, has limited their ability to facilitate l Treasury market activity. The rule is not very favorable to low-risk activities, such as holding treasury bills. A report released last year by the Group of Thirty, an economics advisory body, warned that “the total amount of capital allocated to market making by bank-affiliated dealers has not kept pace” with its rise. dazzling growth.
To combat problems that have arisen in the past, the Fed has taken steps to increase liquidity, such as opening a “standing facility” allowing selected intermediaries to exchange Treasury bills for cash. . But few believe it to be a panacea for dysfunction. Mr. Duffie favors replacing the current market structure, which relies on brokers, with a central clearing system. This would make it easier for market participants to interact directly – for one mutual fund, for example, to sell to another without relying on a bank to mediate the transaction. But the solution would not match “the scale of the problem”, says Quarles. A more pressing task, he said, is to loosen the regulatory shackles that prevent investment banks from supporting the market. This is unlikely to happen soon: there is little appetite in Washington for a weakening of banking regulation.
With no obvious solution, the unknown fallout from the Fed’s pullback adds to the uncertainty created by rising rates, stagflation and geopolitical turmoil. Liquidity in the Treasury market is already thinning: the “yield error” captured by the Bloomberg Treasury Liquidity Index, which measures the difference between the yield at which a Treasury is traded and a measure of fair value, is 12% higher than it was in January. It has more than doubled since August 2021. The growing possibility of a new malfunction could deter investors from continuing to trade, making it even more likely that the market will crash. The once peaceful life of Treasuries and bonds could become more chaotic for a while. ■
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