Investors’ hopes for a strong year for US Treasuries have been boosted by signals that the Federal Reserve could soon slow the wind-down of its balance sheet.
In the minutes of the central bank’s December meeting, published this week, some officials suggested the Fed review its policy of shrinking its balance sheet, known as “quantitative tightening”.
On Saturday, Lorie Logan, the president of the Dallas Fed who used to run the New York Fed’s markets desk, said a rapid decline in the use of a central bank account known as the Overnight Reverse Repo Facility, or ON RPP, warranted the review.
A pivot from the Fed, as it considers cutting rates from their current 22-year high of 5.25-5.5 per cent, could bolster Treasuries’ prices and reduce volatility in a market that has been unsettled by a deluge of supply. The central bank has in recent years been the biggest buyer of US government debt.
“This is a tailwind for the bond market. It should help us,” said Bob Michele, chief investment officer and head of the global FICC group at JPMorgan Asset Management. The end of QT would remove “a concern for investors who are sitting in cash, wondering if they should come into the bond market”.
After pumping trillions into the financial system to stabilise the economy at the start of the coronavirus pandemic, the Fed began slimming its balance sheet from $9tn in May 2022 to help contain the worst surge in inflation since the 1980s.
Since ending its bond purchases, the size of its holdings of official sector debt has fallen to $7.2tn. Now, with price pressures seemingly under control — and rate cuts looming — the text of the minutes show some policymakers want a discussion on the circumstances under which those QT plans can be revised.
“This seems like a first step towards ending QT,” said Joseph Abate, a strategist at Barclays.
The nascent signs of a debate come as the Treasury department has borrowed more to cover a widening budget deficit, which stands at $1.7tn.
The surge of US government bond issuance in the second half of 2023 helped drive Treasury yields to their highest levels in more than a decade, and waning demand from big banks and foreign investors was expected to worsen the effects this year.
“This will bring down the volatility of the rates market,” said Rick Rieder, chief investment officer of global fixed income at BlackRock. “One of the risks this year was the big auctions that Treasury had to execute on. When you have to do such big auctions when the Fed is doing QT, you have risks. This lowers some of [those] risks.”
An end to QT would reduce the amount of debt Treasury needs to issue to private investors this year. Excluding Treasury bill issuance — the short-term debt that matures in anywhere from a few days to a year — issuance this year is expected to be $1.8tn if QT ends in June, versus $2.1tn if it ends in December, according to estimates from Meghan Swiber, a US rates strategist at Bank of America.
A New York Fed survey of Treasury dealers published on Thursday suggested that, as of December, big banks had been expecting the Fed to end QT in the fourth quarter of 2024. Following the publication of the minutes, some investors, including Michele, now expect the run-off to end by summer.
Other Fed watchers are more cautious about expecting a decision so fast. A shift in QT policy comes as central bank officials have indicated they are likely to make three quarter-point rate cuts this year, calling time on a series of rate rises aimed at tackling soaring inflation.
“There’s a desire to avoid any sort of liquidity stress at a point when the Fed is going to be pivoting from what has been a historic tightening cycle,” said Gregory Daco, chief economist at EY. “We know that these pivot points tend to be a sensitive time for markets.”
The size of the ON RRP account — an important indicator of liquidity — has fallen sharply from levels above $2tn around the middle of last year as money market funds have shifted their balances into Treasuries.
Logan said in San Antonio that at, $700bn, the balances held on the ON RRP still provided “comfort that liquidity is ample in aggregate”. However, further falls could challenge that assumption.
“Given the rapid decline of the ON RPP, it’s appropriate to consider the parameters that will guide a decision to slow the run-off of our assets,” Logan said.
Officials have previously said that the Fed would determine when to end QT by assessing the level of reserves in the financial system — as well as a range of money market indicators, such as the spread between private lenders’ funding costs and official interest rates. The Fed currently rolls off up to $60bn in Treasuries and $35bn in mortgage-backed securities each month.
“Talk of QT is quite premature,” said Drew Matus, chief market strategist at MetLife Investment Management. “The balance sheet remains bloated relative to [gross domestic product]. You need to shrink it so that, if there’s another downturn at some point, you can restart quantitative easing.”
QT’s end would likely be gradual, with the Fed expected to increase the portion of the debt holdings it reinvests over several months.
That process could be doubly beneficial for Treasuries, as the Fed is likely to reinvest both its maturing Treasury bonds, and its maturing mortgage-backed securities into the Treasury market, said Swiber. That’s because the Fed has said that it is ultimately interested in having only Treasury debt on its balance sheet.
An early end to QT may also ward off fears of a repeat of the 2019 crisis in the repo market, when the Fed last tightened its balance sheet.
Then, rates in short-term funding markets jumped after a sudden drop in reserves, ultimately forcing the Fed to intervene in the market. While reserves are still ample and there are not clear signs of stress in the market, overnight funding rates have been creeping higher.
“This points to a Fed that wants to err on the side of caution,” said Mike de Pass, global head of rates trading at Citadel Securities. “It’s also important to remember how poorly it ended last time.”
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