Treasury market faces liquidity risks as U.S. Fed pares balance sheet

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The Fed will let bonds mature off its balance sheet without replacement starting June 1 as it attempts to normalize policy and bring down soaring inflation

. This follows unprecedented bond purchases from March 2020 to March 2022, meant to blunt the economic impact of business closures during the pandemic.

The Fed is pulling back at a time when the Treasury market was already struggling with periods of choppy trading. U.S. government debt issuance has soared while banks face greater regulatory constraints, which they say has impeded their ability to intermediate trading. To the degree that the Fed’s retreat does impact yields, it will most likely be higher. Many analysts thought the Fed kept benchmark yields artificially low and contributed to a brief inversion of the Treasury yield curve in April.

“From a top-down macro perspective we think other determinants will be just as or likely even more important for thinking about the direction of yields,” said Credit Suisse’s Cohn. There is also significant excess liquidity in the form of bank reserves and cash lent into the Fed’s reverse repurchase facility, which may take time to work through. Bank reserves stand at $3.62 trillion, up sharply from $1.70 trillion in Dec. 2019. Demand for the Fed’s overnight reverse repo facility, where investors borrow Treasuries from the Fed overnight, set a record at more than $2 trillion last week.

 

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