Baltimore Sun

Fed’s exit puts world’s biggest bond market in a shaky spot

- By Joe Rennison

Traders are worried about the world’s largest and most important government bond market, as the Federal Reserve quickens the pace at which it removes one of its primary pandemic supports.

When the global economy crashed in March 2020 and markets went into free fall, the U.S. Treasury market — the $25 trillion bedrock of the global financial system — broke down. Sellers struggled to find buyers, and prices whipsawed higher and lower. The Fed stepped in, devoting trillions of dollars to steadying the market.

The Treasury market is the main source of funding for the U.S. government and underpins borrowing costs around the world, for a huge variety of assets.

That’s why even small wobbles in this market can generate huge worries.

At its worst, a Treasury trading breakdown could cause the value of the dollar, stocks and other bonds to tumble. Economies that borrow a lot in dollars and hold Treasuries in their reserves would teeter

In response to market turmoil in the early stages of the coronaviru­s pandemic in 2020, the Fed unleashed the full force of its firepower, buying mortgage bonds and government debt in huge quantities, in a move known as quantitati­ve easing, or QE.

The Fed’s balance sheet ballooned from a little more than $4 trillion in early 2020 to a peak of nearly $9 trillion two years later. Stability also brought investment back to the stock market.

Now, the Fed is reversing course through quantitati­ve tightening, or QT, pulling back its support for financial markets while it raises interest rates to quell inflation.

Some investors worry

that the quickening pace of the Fed’s pullback could become too much for markets to bear, underminin­g the safety and reliabilit­y of the Treasury market.

What market watchers are most worried about as the Fed’s balance sheet shrinks is something called liquidity — trader jargon for the ease of buying and selling a financial asset.

When markets are liquid, money flows freely and easily, and investors can buy and sell a financial asset — in this case, Treasuries — at a stable price with little trouble. Illiquidit­y, on the other hand, is like a blocked water pipe; it’s hard to push anything through, and what does get past the blockage comes in spurts, with prices moving sharply higher or lower as trades fail to be fulfilled in a predictabl­e way.

Since June 2021, the Fed has been letting a small number of bonds mature without being replaced. Starting this month, the Fed will allow up to $60 billion of Treasuries and $35 billion of mortgage bonds

to roll off its balance sheet as the debts come due, twice as much as the past three months.

As the Fed backs away, it’s not clear who will fill the void. And even if new buyers for bonds can be found, the reduction in demand caused by the Fed’s exit is raising fears among traders of volatility that could make future market disturbanc­es worse.

The sheer scale of U.S. government debt also plays an important role. The Treasury market has doubled over the past decade, to around $25 trillion, as the government’s financing needs have grown. All that debt needs to be bought by someone and not just the Fed.

If demand for Treasuries can’t keep pace with the supply, it could pull prices down. Prices move in the opposite direction to bond yields, a measure of borrowing costs. Higher Treasury yields would put more pressure on borrowers already grappling with the Fed’s campaign to lower inflation by raising interest rates.

 ?? AL DRAGO/THE NEW YORK TIMES ?? Market watchers are worried about a loss of liquidity as the Federal Reserve’s balance sheet shrinks. Above, the Fed building in Washington.
AL DRAGO/THE NEW YORK TIMES Market watchers are worried about a loss of liquidity as the Federal Reserve’s balance sheet shrinks. Above, the Fed building in Washington.

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