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The Federal Reserve’s drive to shrink its swollen balance sheet is poised to hit $1tn this month, a significant milestone in the US central bank’s attempt to reverse years of easy pandemic-era monetary policy as investors warn further reductions threaten to shake financial markets.
The US central bank bought trillions of dollars of government bonds and mortgage-backed securities to help stabilise the financial system during the early stages of the Covid-19 pandemic, but last spring started letting its holdings mature without replacing them.
As of August 9, the Fed’s portfolio had shrunk by $0.98tn since the portfolio’s peak of $8.55tn in May last year, and analysis of weekly data suggests it is on track to pass $1tn before the end of the month.
By removing one of the largest buyers from government bond markets, the Fed’s balance sheet reduction — known as quantitative tightening — adds to the supply of debt that private investors have to absorb.
For the central bank, quantitative tightening can be a precarious path. It was forced to end its previous attempt in 2019 after the balance sheet unwinding contributed to a sharp spike in borrowing costs that spooked markets.
So far, the latest round of tightening has proceeded smoothly, despite happening at almost twice the pace of 2018-2019 reductions. Investors say the resilience reflects the fact that the global financial system has been awash in cash since the pandemic, but the backdrop for further decreases is becoming more challenging.
“The second trillion worth of balance sheet reduction is likely to have more of an impact,” said Jay Barry, co-head of US rates strategy at JPMorgan. “The first trillion occurred against the backdrop of the federal funds rate moving rapidly higher, and the second trillion matters more because it’s coming against the backdrop of a quicker increase in the pace of Treasury supply.”
The Fed aims to cut another $1.5tn from its balance sheet by mid-2025, just as the US government is dramatically increasing the amount of debt it issues, and as demand from foreign investors wanes.
That threatens to drive up borrowing costs for the government and for companies, and would cause losses for the many investors who have piled into bonds this year expecting yields to fall as the cycle of interest rate rises draws to a close.
Manmohan Singh, a senior economist at the IMF, said a further $1tn of QT would be equivalent to lifting the federal funds rate by another 0.15 to 0.25 percentage points.
“With interest rates stabilising, the effects of more QT may be easier to see,” he said.
The Treasury department has ramped up bond issuance this year to fill the gap between lower tax revenue and higher government spending. Earlier this month, the agency announced that it would increase the sizes of its auctions in the coming quarter, and that there would be further increases in the quarters to come. Meghan Swiber, a rates analyst at Bank of America, estimates that some auction sizes could reach the peaks hit in 2021, at the height of Covid-19 borrowing.
Meanwhile, demand from Japan, the largest foreign holder of Treasury bonds, is forecast to fall. The Bank of Japan in July eased control on its government bond market, sending Japanese bond yields to the highest level in almost a decade. Higher bond yields have led some investors to anticipate a significant repatriation of Japanese money, with notable flows out of Treasuries.
QT, even in this scenario, is not expected to result in the sort of liquidity calamity seen in 2019. Unlike four years ago, there is still a lot of cash in the financial system. Although usage has come down, a special Fed facility designed specifically to suck up excess cash still has investors putting $1.8tn into it every night. Bank reserves are lower this year, but remain far above the levels at which the Fed starts to worry.
But some analysts think yields in the Treasury market could go up significantly, particularly on longer-dated bonds. Higher yields reflect lower prices.
“The Fed’s unwind, even though it’s passive, should lead to a steeper yield curve,” Barry said.
“Even though we’re done with rate hikes, [QT] could influence the yield curve for the rest of this year and into next year as well.”
Because Treasury yields underpin valuations across asset classes, a significant rise would also mean higher costs for corporate borrowers and could undermine the rally in equities this year.
“All of this shuffles around the buyers and the sellers and the market,” said Scott Skyrm, a repo trader at Curvature Securities. “And, of course, when you move things around, it tends to create more volatility. I expect more volatility in September and October, as a lot more issuance comes.”
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