The Federal Reserve now owns about a third of both Treasury bill and mortgage-backed securities markets as a result of the emergency asset purchases to support the US economy during the Covid-19 pandemic. Two years of so-called quantitative easing doubled the central bank’s balance sheet to $9 trillion, equivalent to about 40% of the nation’s gross domestic product. By adding so much liquidity to the financial system, the Fed has contributed to significant gains in the stock, bond and housing markets and other investment assets.
With inflation rampant, the Fed is draining this liquidity through a process known as: quantitative tightening, or QT. In June, the central bank began shrinking its portfolio by rolling or maturing up to $30 billion in government bonds and $17.5 billion in mortgage-backed securities, or MBS, without reinvesting the proceeds. The amount will double this month and effectively begins on September 15, as Treasury bills are redeemed mid-month and at the end of the month.
QT is as ambitious as its impact is uncertain. At full throttle, the pace of balance sheet tightening will be much more aggressive than in the past, and at a time when interest rates are rising rapidly. What could go wrong? Possibly, a lot, suggests Joseph Wang, a former Fed open market counter trader and author of the Fed Guy blog and Central Banking 101. Wang explains what’s at stake in the edited conversation that follows.
Barron’s: How will quantitative tightening unfold and how will accelerated redemptions affect the market?
Joseph Wang: When the economy was not doing well, QE put downward pressure on interest rates and increased liquidity in the financial system. Now the Fed wants tighten financial conditions. QT increases the number of Treasuries available to investors while reducing their cash holdings. Mechanically, the US Treasury issues new debt to an investor and uses the issuance proceeds to repay the Fed’s Treasuries. The Fed takes that money and then just cancels it — the opposite of what happened during QE, when the Fed created money out of thin air.
When you increase the supply of bonds in a not very liquid market, and when the marginal buyer changes as the Fed pulls back, you get volatility. Markets haven’t priced in what that means. We will likely see higher fixed income returns. Higher returns affect stocks in a number of ways. There is the impact of portfolio rebalancing where losses on the bond side of a portfolio would prompt an investor to sell some stocks to restore balance. QT also reverses the risk-on effect of QE, which occurred when many investors seeking yield moved into riskier assets or longer-dated government bonds.
This is happening at a time when a lot of government bonds are being issued. Why is that important?
Market pricing is driven by supply and demand, and in the coming years there will be a huge supply of government bonds from two sources. First, there are the budget deficits that the US government has. While the deficit will shrink a bit this year compared to last year, the Congressional Budget Office says the trajectory is effectively a trillion dollars a year for Treasury bill issuance for the foreseeable future. The second source of additional supply is QT. Together, these will push the supply of government bonds this year and next to historically high levels of about $1.5 trillion. Before Covid, the net supply was about $500 billion.
On the demand side, the marginal buyer is changing as the Fed moves away from the Treasury and mortgage markets. The hedge funds are not there. The Fed is not there. And the banks are not there. We don’t have to go through a price discovery phase. Keep in mind the context: treasury markets liquidity is currently weak. There is some vulnerability and it will likely be highlighted as QT increases.
Speaking of the marginal buyer, who will fill the void if the Fed backs down? Can these markets function without the Fed?
I’m not sure who the new buyer will be, which is why I think there could be significant volatility in interest rates. But new buyers can be manufactured through policy. One way is through a Treasury buyback program, where the Treasury becomes a major buyer of government bonds. The Treasury department recently put this idea forward. Another way that new purchases can be encouraged by banks is through regulatory changes, where regulators reduce banks’ capital requirements, encouraging them to buy more government debt.
But the thing is, if issuance grows by a trillion dollars a year, it’s hard to say there will ever be enough fringe buyers. We are locked in a world where there will always be QEbecause eventually the Fed will have to become the buyer again. Treasury bill issuance is growing faster than the market itself can handle.
Recall that in the past 20 years the amount of outstanding government bonds has more than tripled, but the average daily volume in the money market has grown much more slowly. That is inherently unstable. It’s like a stadium that keeps getting bigger while the number of exits stays the same. If a lot of people have to get out, as happened in March 2020, then the market is in trouble.
Fed officials say they don’t know much about how QT will turn out. Why is that?
The way QT unfolds depends on moving parts, and much of it is beyond the Fed’s control. First, there is uncertainty about what the Treasury spends. It could issue many longer-term Treasury bills, which the market will have more difficulty digesting, or more shorter Treasury bonds, which the market will be able to digest more easily. Depending on what the Treasury does, the market may have to digest much more dearly, which would be: disruptive in a Treasury market where liquidity is already thin.
Where liquidity is released is also beyond the Fed’s control. When the Treasury issues new securities, they can either be purchased by cash investors, such as banks, or leveraged investors, such as hedge funds. When bought by leveraged investors, the money that will fund them will most likely come from the Fed’s reverse repo facility, or RRP, an overnight lending program that you can think of as excess liquidity in the financial system.
If the newly issued Treasuries are bought by leveraged investors, it leads to the outflow of liquidity that the financial system doesn’t really need, so the impact is neutral. But when the newly issued securities are bought by cash investors, someone takes money from the bank and uses it to buy government bonds to pay back the Fed. In that case, the banking sector loses liquidity, which can be disruptive because it is possible that someone, somewhere, is dependent on that liquidity. That’s what happened in September 2019 when the repo market stalled and the Fed had to add more reserves.
It seems that you are afraid that something will break again. Why?
It is impossible for the Fed to know how liquidity will be drained from the financial system. But we can see who’s buying these days, and buying almost all comes from the banking system, unlike parties like hedge funds. The suggested retail price has been stable at around $2 trillion since the beginning of the year. So it appears that QT will draw liquidity from the banking sector rather than from the RRP.
That’s the opposite of what the Fed wants. Officials assumed they could aggressively ramp up the pace of QT as they see a lot of liquidity parked in the RRP. What they may not understand is that they have no control over how liquidity is drained. And right now, as noted, it comes out of the banking system.
Fed Chair Jerome Powell said in July that QT would last between two and 2½ years. That suggests the Fed’s balance sheet will shrink by about $2.5 trillion. Is that a realistic assumption?
The Fed believes QT is limited by the amount of liquidity banks need to function properly. They believe that the balance sheet could fall by about $2.5 trillion, and that would be a good thing. But remember, the Fed doesn’t have much control over how liquidity is drained. It seems they want the banking sector to have more than $2 trillion in reserves. Right now, the banking sector has about $3 trillion. The only way QT can continue as currently predicted is to ensure that liquidity is drawn more evenly from the financial system, meaning more liquidity is coming out of the RPP than from the banking sector. If the Fed can’t find a way to strike that balance, it may have to pull out early. But there are ways they can make this work.
What are they?
There are two primary solutions to the problem of too much liquidity flowing out of the banking sector while much remains in the RRP. First, the Fed can do what it did in the fall of 2019 and start buying a lot of Treasury bills. From the Fed’s perspective, bill buying is not the same as QE. They basically exchange short-term assets for reserves, which are also short-term assets, deliberately adding reserves to the system without affecting interest rates.
Second, and more likely, the Fed could work with the Treasury. If the Treasury buys back by issuing short-term bills and uses the proceeds to buy longer-term coupons, it would move liquidity out of the RRP and into the banking system because the Treasury bills would be bought by money market funds holding money in the RRP . The sellers of the coupons to the Treasury would then deposit the money at a commercial bank. Moving money from the RRP into the banking system would allow the Fed to continue QT without worrying about liquidity in the banking system dropping too much.
Will the Fed End the Sale? mortgage-backed securities?
It plans to pay off up to $35 billion a month in agency mortgages, but it estimates it will only be able to do about $25 billion a month. Unlike Treasuries, whose principal is paid on maturity, mortgages can be prepaid. For example, if someone who owns a home refinances, they take out a new loan to repay an old loan. When selling a house, they can use the proceeds to pay off the mortgage. That all slows down as mortgage rates rise.
Selling MBS is another tool the Fed has to tighten financial conditions, but it seems they don’t want to use it. The housing market has eased considerably in recent months. I can imagine that they would like to see how this plays out before further tightening the financial conditions for housing.
Thank you, Joseph.
Write to Lisa Beilfuss at [email protected]