Fed’s Balance Sheet Underwater Due To Treasury Volatility

Fed’s undermined books were incited by increased volatility and low liquidity in the US treasury debt market. This begs the question, should the Federal Reserve reassess its game plan?

Fed’s Books Crater Over Yield Imbalance

Over the past five months, the United States Federal Reserve has had its quantitative tightening policy active. It was designed to pull out the Covid-19 incentives still circulating in the economy. Meanwhile, Fed’s balance sheet fell from a high of $9 trillion to $8.7 trillion.

A considerably modest decline. However, the Fed had the motive to read out $95 billion from its record in September. That is, it would desist from investing the returns from mortgage-supported securities and treasury yields.

But, unfortunately, it encountered a setback with the treasury yield during its hawkish rates policy rodeo. Experts tracked the issue down to a lasting US banking framework that followed the 2008 financial meltdown. After the fact, banks strategized new operations methods to prevent the scenario’s recurrence. 

Currently, the agency is moving to downsize its balance sheet even more. But, if that doesn’t work and the situation goes haywire, the policymakers might resort to closing the lid on it. In a research note written by a US bond strategist at BCA Research, Ryan Swift, he noted that the March 2020 scenario might get a repeat of bond volatility keeps increasing.

Fed Is Likely To Quit Quantitative Tightening Policy

Consequently, the Federal Reserve will have no choice but to buy out treasury securities and wrap up its quantitative tightening policy. Also, some economists at UBS stated that the Fed’s books reduction move will encounter challenges through 2023. Eventually, Fed might be pushed to squash the process sometime in June next year. 

Investors monitor the liquidity premium of new issues or on-the-run treasuries. Meanwhile, they leave out the off-the-run treasuries which are over the hill. These particular sets carry a substantial part of matured debts and amount to 25% of the daily trading volume.

Current treasuries usually hold more recognition compared to old ones. As per an analysis by BCA, the current ten-year treasury yield is at its broadest since 2015, unlike its senior peer. In a research paper, Morgan Stanley declared that off-the-run liquidity tends to get compromised quickly.

That includes its five-year, ten-year, twenty-year, and thirty-year ticker. 

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