How Much Longer Will QT Remain in Place with Long-Term Treasury Yields Surpassing 5%?

With major overseas buyers, US banks, mutual funds, and other investors showing weak demand for Treasury purchases, the Federal Reserve - the largest holder of US public debt - may face pressure to reconsider the QT process. This is because surging borrowing costs could increase the risk of a hard landing for the economy and jeopardize important sectors such as equities, corporate credit, and real estate.

Since the current round of QT began in June 2022, the Fed's assets have cumulatively shrunk by over $1 trillion - dropping from over $8.95 trillion to $7.93 trillion in just 17 months - at a pace almost twice as fast as the prior QT round (2017-2019).

Despite the balance sheet surging by almost $400 billion in mid-March 2023 due to regional banking crises that disrupted the national banking system, the size has since declined again and remains on a downward trend. The Fed has remained resolute about tapering, noting that it could continue into next year.

The Fed has primarily reduced its assets by decreasing the size of securities held outright, mainly U.S. Treasuries and mortgage-backed securities (MBS), which comprise over 90% of the Fed's total assets.

As of October 25th, 2023, the Fed's Securities Held Outright had decreased from a high of $8,500 billion in 2022 to $7,377 billion, representing a decline of approximately 13%. Treasury holdings had dropped by more than $850 billion, while mortgage-backed securities had experienced a decline of about $240 billion.

In line with the reduction in assets, the Fed's liabilities have decreased significantly. Quantitative tightening (QT) has primarily achieved this through reductions in reverse repurchase agreements (RRPs) and commercial bank reserves. Since the current round of QT began, the Fed's RRP has significantly decreased by over $850 billion, whereas bank reserves have remained largely unchanged.

Several analysts are expressing concern that QT may be a risky and uncertain path.

After adjustments to the US debt ceiling and the new budget bill in early June of this year, US Treasury issuance surged. However, demand for US Treasuries has weakened significantly, despite these developments. This is apparent not only from weak auctions of Treasuries with multiple maturities in the primary market but also from continuous divestments by major buyers such as overseas holders, mutual funds, and US banks. The mismatch between supply and demand for US Treasury may increase liquidity pressure and volatility risks.

2. Potential downward pressure on bank reserves will affect the stability of the financial system

While liquidity tightening is currently being drained primarily from the Fed's reverse repurchase agreements, bank reserves do not appear to have been impacted significantly. However, the risk of a fall in bank reserves as reverse repos are depleted is both theoretically and empirically plausible. Such an event could eventually compel the Fed to terminate its quantitative tightening program.

The Fed's balance sheet reduction undermines its support for significant fiscal deficits, particularly in light of the first operating loss it faces in a century due to the depreciation of US debt assets it holds. This action curtails the amount of money that the Fed transfers to the Treasury. Fiscal constraints may also be a crucial factor for governments to consider when evaluating the pace and magnitude of QT.

In September 2019, a liquidity crisis rattled the US short-term financing market, driving the overnight repurchase rate up to 10%. The reduction in bank reserves led to financial market upheaval, forcing the Federal Reserve to inject enormous amounts of money into the market and halt QT.

The Federal Open Market Committee stated in May 2022 that it plans to maintain securities holdings necessary to conduct monetary policy effectively under its ample reserve system. The FOMC is hopeful that banks are well-stocked, but if the balance sheet reduction reduces Fed-held reserves, it could create scarcity and prompt the Fed to reconsider the pace of QT.

Wells Fargo analysts predict that if the economy falls into a recession and the FOMC pivots from rate hikes to cuts, QT will continue until the end of Q2 2024 when balance sheet shrinkage is expected to cease. In the absence of a recession and if the US economy has a "soft landing," the FOMC may still lower the federal funds rate gradually to shift monetary policy toward a more neutral environment.

The possibility of QT ending earlier could assist in stabilizing a disorganized Treasury market and reducing potential financial and housing market risks.

Contrary to market speculation, the Fed does not appear to believe that QT should end sooner than anticipated. Despite acknowledging that a surge in long-term Treasury yields may lessen the need for raising benchmark interest rates, QT could proceed as planned.