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Fed begins quantitative tightening on unprecedented scale

The mammoth task of shrinking the Federal Reserve’s $9 trillion balance sheet has finally begun.

On Wednesday, the U.S. Federal Reserve will stop pumping the proceeds of an initial $15 billion in maturing government bonds back into the $23 trillion U.S. government debt market, the first time it has done so since ending its bond-buying program. kicked off the start. days of the coronavirus pandemic.

Although the Fed has announced its plans for so-called quantitative tightening well in advance, it is unclear to investors what the impact will be from a process that has never been attempted before on such a scale. The move could further upset a bond market already battered by speculation that the Fed is poised to accelerate the pace of its rate hikes.

“The Fed has been a major buyer and a major stabilizing influence in the markets for a few years now,” said Rick Rieder, chief investment officer for fixed income at BlackRock.

“Losing that, with the uncertainty of inflation and growth, means that interest rate market volatility will be high, much higher than we’ve seen in recent years,” he added.

The unease in the financial markets challenges the Fed’s claim that balance sheet reduction will be a dull, predictable undertaking — akin to “watching the paint dry” by former chair Janet Yellen, the last time the central bank started the exercise in 2017 .

As was the case then, the Fed is letting bonds mature and will not reinvest the money, rather than sell them outright – a more aggressive alternative.

Line chart of $trillions showing the Fed's balance sheet has risen

Federal Open Market Committee members officially agreed in May to cap the run-off at an initial pace of $30 billion a month for Treasuries and $17.5 billion for agency mortgage-backed securities before it goes into effect. three months was ramped up to a maximum rate of $60 and $35 billion respectively. That works out to a whopping $95 billion per month.

When the amount of maturing Treasury bills falls below that threshold, the Fed will make up for the difference by reducing its holdings of short-term Treasury bills. In the long term, active sale of the MBS agency could also be considered.

That’s a much more aggressive plan than the last balance sheet settlement in 2017-19, which began nearly two years after the Fed raised interest rates for the first time since the global financial crisis. That move ended in disaster as the overnight lending markets intervened, indicating that the Fed had taken too much money out of the system.

As the process gets underway this time around, it’s unclear exactly where the pain will be, though the Fed now has several emergency facilities available that could help prevent a repeat of the chaos in the market of 2019.

Anticipation of higher interest rates – particularly after two reports in recent days pointing to a growing risk that inflation will become more entrenched – has propelled government bond yields to their highest levels since 2007. The three major US stock indices have entered correction territory. US corporate bond spreads show a higher probability of default.

Changes in the Fed’s key policy rate are seen as having a more direct effect on financial conditions and economic activity than quantitative tightening, but economists expect the deleveraging to have an effect as well.

When the Fed buys bonds, it credits the seller electronically, adding reserves to the banking system that then allow banks to increase their lending to individuals and businesses. By no longer reinvesting the proceeds of the bond portfolio, the process is reversed, leading to fewer reserves in the system and tighter financial conditions.

In a paper published by the central bank earlier this month, researchers suspected that reducing the size of its balance sheet by about $2.5 trillion over the next few years is “roughly equivalent” to raising the federal fund rate by slightly more than half a percentage point “on a sustainable basis.” However, they made their findings subject to a disclosure that the estimate is “associated with significant uncertainty.”

Christopher Waller, a Fed governor, has previously said the central bank’s plan to shrink its balance sheet amounts to “a few” quarter-point rate hikes, while Vice-Chairman Lael Brainard said in April the process was worth it overall. could be “two or three additional fare increases”.

Some analysts, including Bank of America’s Meghan Swiber and Columbia Threadneedle’s Edward Al-Hussainy, argue that the market has already anticipated the immediate tightening effects of balance sheet normalization, as described by top Fed officials and reflected in asset prices.

But the Fed’s pullback is also likely to have a secondary effect on prices, as liquidity — the ease with which investors can buy and sell assets — deteriorates as markets struggle with a larger amount of bonds to absorb.

“We understand that the Fed’s involvement in the market and buying Treasuries helps improve liquidity and improve market functioning,” Swiber said. “And now we’re going to be in an environment where there’s more supply that needs to be reduced, and the Fed isn’t there to help.”

That means the magnitude and frequency of price swings could worsen as the Fed pulls out of the market, particularly in the Treasury market, where the central bank has had the largest presence. But because the Treasury market is the backbone of all US financial markets, those securities ripple.

According to a Bloomberg index that measures traders’ ability to execute deals without impacting prices.

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