Investors are preparing for turmoil as the Federal Reserve’s balance sheet shrinks by $1 trillion

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The Fed’s campaign to shrink its bloated balance sheet is expected to reach $1 trillion this month, a milestone in the US central bank’s attempt to reverse years of easy monetary policy in the pandemic era as investors warn that further cuts threaten to unsettle financial markets.

The US central bank bought trillions of dollars in government bonds and mortgage-backed securities to help stabilize the financial system during the early stages of the Covid-19 pandemic, but last spring it began letting its holdings mature without replacing them.

As of Aug. 9, the Fed’s portfolio had shrunk by $0.98 trillion since the portfolio’s peak of $8.55 trillion in May last year, and analysis of the weekly data suggests it’s on track to surpass $1 trillion before the end of the month.

By removing one of the largest buyers from government bond markets, the Fed’s balance sheet reduction — known as quantitative tightening — adds to the supply of debt that private investors have to absorb.

For the central bank, quantitative tightening could be a risky path. It was forced to end its previous attempt in 2019 after the cannibalization of the balance sheet contributed to a sharp rise in borrowing costs, which spooked the markets.

So far, the latest round of tightening has proceeded smoothly, though it has occurred at nearly twice the pace of the 2018-2019 reductions. Investors say the resilience reflects the fact that the global financial system has been awash in liquidity since the pandemic, but that the backdrop for further declines is becoming more challenging.

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“The second trillion balance sheet cut is likely to have an even bigger impact,” said Jay Barry, co-head of US interest rate strategy at JPMorgan. “The first trillion happened on the back of a rapidly rising federal funds rate, and the second trillion is even more important because it comes on the back of a faster increase in the pace of Treasury supply.”

The Fed aims to cut another $1.5 trillion from its balance sheet by the middle of 2025, just as the US government dramatically increases the amount of debt it issues, and as demand from foreign investors wanes.

This threatens to raise borrowing costs for government and companies, and will lead to losses for many investors who have piled into bonds this year and expect yields to fall as the cycle of rising interest rates draws to a close.

An additional $1 trillion QT would equate to raising the federal funds rate by another 0.15 to 0.25 percentage point, said Manmohan Singh, chief economist at the International Monetary Fund.

“As interest rates stabilize, it may be easier to see the effects of increasing QT,” he said.

The Treasury Department has ramped up bond issuance this year to bridge the gap between lower tax revenues and higher government spending. Earlier this month, the agency announced that it would increase its auction volumes in the next quarter, and that there would be further increases in the coming quarters. Megan Sweber, a pricing analyst at Bank of America, estimates that some auction volumes could peak as they did in 2021, at the height of Covid-19 borrowing.

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Meanwhile, demand from Japan, the largest foreign holder of Treasury bonds, is expected to decline. The Bank of Japan in July loosened its grip on the government bond market, sending Japanese bond yields to the highest level in nearly a decade. Rising bond yields have led some investors to anticipate a large repatriation of Japanese money, with notable inflows from Treasuries.

Qt, even in this scenario, is not expected to lead to the kind of liquidity disaster we saw in 2019. Unlike four years ago, there is still plenty of liquidity in the financial system. Even though utilization has fallen, a special Federal Reserve facility specifically designed to absorb excess cash still has investors investing $1.8 trillion each night. Bank reserves have fallen this year, but remain well above levels at which the Fed begins to worry.

But some analysts believe yields in the treasury market could rise significantly, particularly on long-term bonds. Higher returns reflect lower prices.

“The Fed unwinding, while negative, should lead to a steeper yield curve,” Barry said.

“Even though we ended up raising prices, [QT] It could affect the yield curve for the rest of this year and into next year as well.”

With Treasury yields supporting valuations across asset classes, a big rally could also mean higher costs for corporate borrowers and could dampen the rally in equities this year.

“It’s all going back and forth between buyers and sellers and the market,” said Scott Skyrim, a repo trader at Curvature Securities. “And of course, when you move things around, it tends to create more volatility. I would expect more volatility in September and October, as more issues come in.”

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