By Michael S. Derby
NEW YORK (Reuters) – The bond market turmoil that has caused real borrowing costs to rise is unlikely to stop the Federal Reserve from continuing to shed nearly $100 billion in bonds every month from its $8 balance sheet trillion, analysts say.
That’s because interest rates have been relatively orderly, even if they have been excessive, even as rates have soared and new concerns have arisen about a possible recession. Key measures of bond market volatility and liquidity are not showing the warning signals they did last spring, when Silicon Valley Bank failed and forced the Fed to launch a new emergency lending facility for banks.
Moreover, the more expensive credit is in line with central bank officials’ desire to raise interest rates to levels restrictive enough to slow growth and bring inflation back to the 2% target.
“I don’t think the Fed would halt QT (quantitative tightening) unless there is a structural liquidity problem in the Treasury market,” said Kathy Bostjancic, chief economist at insurance company Nationwide.
Since June 2022, the Fed has matured more than $1 trillion in bonds from its portfolio, including about $840 billion in Treasury bonds. In addition to the Fed’s 5.25 percentage point rate hikes since March 2022, QT aims to withdraw stimulus from the economy, although officials emphasize that interest rates are their main tool.
The QT process “plays only a minor role in the rise” in market interest rates, Bostjancic said, and those gains are “really due to markets following the Fed’s higher-for-longer advice” on the embrace interest.
The “stop QT-soon” argument rests on the view that bond yields have risen too much and liquidity is too poor, so that ending portfolio depletion could ease upward pressure on rates.
And the market pressure is real: In the two weeks since the Fed’s last meeting, 10-year bond yields have risen more than 50 basis points to nearly 4.9%, including a 15 basis point increase on Friday after nonfarm payroll growth for September came in at almost double what was expected. A closely watched index from Goldman Sachs showed U.S. financial conditions near the tightest of the year on Wednesday.
A FRESH HEADWIND
So far, Fed officials themselves are unperturbed.
Loretta Mester, president of the Cleveland Fed, said Tuesday that “those tighter or higher interest rates are going to have an impact on the economy over the next year and we just have to take that into account as we set monetary policy.”
Meanwhile, Chicago Fed President Austan Goolsbee said in a Bloomberg podcast Thursday that the market move “isn’t a puzzle…it’s clear that the long-term yields coming are what you would expect.”
On the other hand, this could lead to more interest rate increases.
San Francisco Fed President Mary Daly said Thursday with the rise in market rates, “The need for us to take further action is reduced because the financial markets are already moving in that direction and they have done the work.”
While they don’t see current events putting an end to QT, some analysts see a growing case for ending it next year.
QT drains liquidity from the banking system, reducing bank reserves parked at the Fed and money stored in the reverse repo facility. The Fed wants to have enough reserves to allow firm control over the fed funds rate, but no more, and finding that sweet spot is difficult.
Michael Barr, the Fed’s top banking regulator, said Monday that the Fed is “paying attention” to the reserves issue, noting that “that’s something we’re moving toward on instinct — we’re there now, today, for a long time not around.”
HOW LONG?
The Fed’s first attack on QT ended abruptly in September 2019, when the Fed went too far and lost control of the target rate. Some fear this could happen again.
“We didn’t get much warning last time,” UBS strategist Michael Cloherty said Thursday at an event held by the Bank Policy Institute, a Washington lobbying group. If there is a shortage of reserves this time, “I think we’ll run into it with little warning.”
Others believe that money market rates will start to rise in a way that indicates the system is running short of cash. A canary in the coal mine could be the Fed’s Standing Repo Facility, a largely untested safety valve for market stress that could lead to a sudden surge in demand.
There is no clear idea of a timeline as to when QT might end.
An April New York Fed report predicted an end to QT around mid-2025. A survey of major banks by the New York Fed released in August predicted an end to QT in mid-2024.
Mark Cabana, rates strategist at Bank of America, said QT probably still has about a year left and reserves are already scarcer than many realize because banks are already hoarding cash.
“We would say that banks are already liquidity stressed, and if that’s true, how long can QT really last? It can only really last until the RP is substantially depleted overnight,” Cabana said.
Daily reverse repo balances have fallen by more than $1 trillion since early April to just over $1.6 trillion on Wednesday, Fed data showed. At the current pace, Cabana said the end point will likely be in about 13 months.
