Eyes are on the Treasury market as the Federal Reserve lets bonds mature off its $9 trillion balance sheet. The quantitative tightening (QT) that began June 1 is an attempt to tamp down inflation, and analysts say the results will depend on the direction of the overall economy and other factors.
Between March 2020 and March 2022, the Fed made unprecedented bond purchases aimed at easing business shut-downs caused by the COVID-19 pandemic.
The Treasury is the world’s largest holder of U.S. government debt, and as it shrinks its balance sheet, some analysts are worried that market conditions could worsen.
“The impact of QT will be more evident in places like money markets and in market functioning as opposed to yield levels and curves,” Jonathan Cohn, Head of Rates Trading Strategy at Credit Suisse, told Reuters. He said he’d observe “the way in which it proceeds through deposits, through the withdrawal of liquidity, and through the added burden that it places on dealers.”
The Treasury market had already been dealing with uneven trading. U.S. government debt issuance has kicked up, and banks have faced increased regulatory constraints, making it harder for them to intermediate trading.
Also, banks have reduced bond purchases, and some hedge funds have pared their presence after suffering losses during bouts of volatility. Additionally, foreign investors have shown less interest in U.S. debt as hedging costs rise and an increase in foreign bond yields offers more options.
If the tightening does impact yields, analysts say they will most likely be higher, believing that the Fed kept benchmark yields artificially low and contributed to a brief inversion of the Treasury yield curve in April.
“The risk is the market is unable to absorb the additional supply and you do have a big adjustment in valuations,” Gennadiy Goldberg, Senior U.S. Rates Strategist at TD Securities, told Reuters. “We will still see more long-end supply than we did pre-COVID for quite some time, so all else being equal that should pressure rates a bit higher and the curve a bit steeper.”