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The Federal Reserve is on track to reach a significant milestone this month – a $1tn reduction in its bloated balance sheet. This move is part of the US central bank’s efforts to reverse the easy monetary policies implemented during the pandemic, but investors are concerned that further reductions could destabilize financial markets.
During the early stages of the Covid-19 pandemic, the Fed purchased trillions of dollars’ worth of government bonds and mortgage-backed securities to stabilize the financial system. However, it started allowing these holdings to mature without replacing them in the spring of last year.
As of August 9, the Fed’s portfolio had already shrunk by $0.98tn since its peak in May 2021, and it is expected to surpass $1tn by the end of this month. The reduction in the Fed’s balance sheet, known as quantitative tightening, increases the supply of debt that private investors must absorb as one of the largest buyers in government bond markets exits.
Quantitative tightening can be a risky path for the central bank. In 2019, it had to abandon its previous attempt due to a sharp increase in borrowing costs, which spooked the markets. However, the current round of tightening, despite being almost twice as fast as previous reductions, has been smooth so far. This is attributed to the abundance of cash in the global financial system since the pandemic. Nevertheless, future decreases may present more challenges.
Jay Barry, co-head of US rates strategy at JPMorgan, believes that the second trillion worth of balance sheet reduction will have a greater impact. The first trillion occurred against the backdrop of rapidly rising federal funds rates, whereas the second trillion is happening amid a quicker increase in Treasury supply.
The Fed plans to cut another $1.5tn from its balance sheet by mid-2025, coinciding with a substantial increase in US government debt issuance and a decrease in demand from foreign investors. This could lead to higher borrowing costs for the government and companies, as well as losses for investors who have bet on falling yields.
According to Manmohan Singh, a senior economist at the IMF, another $1tn of balance sheet reduction would be equivalent to raising the federal funds rate by an additional 0.15 to 0.25 percentage points. The effects of further quantitative tightening may become more visible as interest rates stabilize.
The US Treasury department has increased bond issuance to bridge the gap between lower tax revenue and higher government spending. Auction sizes are expected to grow, and demand from Japan, the largest foreign holder of Treasury bonds, is predicted to decline. The recent easing of control by the Bank of Japan on its government bond market has led to higher Japanese bond yields, potentially triggering significant repatriation of Japanese money and resulting in outflows from Treasuries.
It is not anticipated that the current round of quantitative tightening will cause a liquidity crisis like in 2019 because there is still ample cash in the financial system. While bank reserves have decreased this year, they remain at levels that do not concern the Fed.
However, some analysts believe that Treasury yields, especially on longer-dated bonds, could rise significantly, leading to lower bond prices. This unwinding by the Fed, even though it is passive, is expected to affect the yield curve throughout this year and beyond, influencing valuations in various asset classes and potentially increasing costs for corporate borrowers. This could have implications for the equity market, with expectations of increased volatility in the upcoming months as more issuance occurs.
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