‘Fragile Liquidity’ in Bond Market Could Threaten Fed’s QT Plans

(Bloomberg) — The unwind of the Federal Reserve’s balance sheet is running at its maximum capacity, though just how long it could go depends on whether global bond markets can continue to function without incident.

Goldman Sachs strategists say any volatility shock will lead to further deterioration in market liquidity, something that global central banks are unlikely to tolerate. Supply of liquidity has been poor, they note, with top-of-book market depth in several places close to its worst levels in five years.

Bond markets are already starting to show lines of massive dislocation as trading in US Treasuries has experienced some of the largest swings since the early days of the pandemic, while the gilts market has seen the wildest moves on record. The most recent ructions in the UK forced the Bank of England to buy bonds and take other steps to ensure the market continues to function. This has ignited concerns that the Fed will eventually have to prop up the nearly $24 trillion Treasury market.

“Both the Fed’s large scale purchases back in March/April 2020 and the BoE’s recent intervention were primarily to restore orderly functioning, and highlight the potential for microstructure issues to short-circuit a central bank’s QT plans,” Goldman Sachs strategists led by Praveen Korapaty wrote in a note to clients. “While we don’t anticipate any issues with the Fed’s current QT plan in the near term, the odds of an accident will likely rise as we go deeper into the QT process.”

Now that the US central bank is no longer the largest buyer of Treasuries, it’s unclear who will replace the Fed as the buyer of last resort. Foreign monetary officials purged $29 billion in Treasury securities in the week ended Oct. 5, bringing the four-week decline in holdings to $81 billion, according to Federal Reserve data. It’s the most-extreme outflow since March 2020, leaving total holdings at $2.91 trillion. At the same time, large commercial banks in the US are already shrinking their securities portfolio, versus last year when they were still buying.

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Policy makers believe markets are operating effectively, citing the Fed’s myriad of tools that could serve as a liquidity backstop during times of financial stress, such as central bank liquidity swap lines and the domestic and foreign repurchase agreement facilities.

Still, Goldman’s strategists have noted that while the Fed’s repo facilities provide alternative means of market intermediation and raising liquidity, they “aren’t perfect substitutes for risk transfer capacity.”

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