schreef:
In
June 2022,
the Federal Reserve began to normalize its large balance sheets from the extraordinary response to the COVID pandemic. In addition, the Fed is also expected to
increase rates substantially over the next two years while engaging in quantitative tightening. Our framework has important implications for the dynamics of the Treasury market during such a tightening cycle.
We first note that
tightening cycles are often associated with flat or
inverted Treasury yield curve, and low expected returns on long-term Treasury bonds.
This dampens the real money investors’ demand for Treasury bonds, and it is particularly challenging for dealers and levered investors to accommodate a reduction in Fed holdings of Treasury bonds (QT) when client demand is weak.Consider the experience of the 2017-2019 tightening cycle, in which the Federal normalized its balance sheet for the first time post-GFC and increased the short-term interest rates from the zero-lower-bound to 2.5 percent. During that tightening cycle, dealers’ increased their Treasury holdings by about $100 billion and hedge funds increased their holdings by about $350 billion, together accounting for the entirety of the $390 billion Fed balance sheet normalization from Oc- tober 2017 to September 2019. The swap-Treasury spread and the Treasury cash-futures basis widened considerably over the period. Moreover,
the increasingly crowded dealer balance sheet and significant build-up of the levered investor positions may have contributed to the repo market distress in September 2019 and
Treasury market dislocation in March 2020.
Consistent with this experience, our framework suggests that
the combination of QT with an active ONRRP facility and a flattening curve, in the long regime, can lead to high bond yields, more negative swap spreads, and
higher financial intermediation spreads. SLR exemptions and the use of the swap lines established with foreign central banks have the potential to ameliorate these effects.