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Treasury market faces liquidity risks

The Federal Reserve set to begin by letting bonds mature off its $9 trillion balance sheet. The key metric to watch will Treasury volatility picks up as a result in a market already suffering bouts of low liquidity. The Fed’s quantitative tightening could also send yields higher. This will depend on the direction of the economy.
The Fed will let bonds mature off its balance sheet without replacement starting June 1. This is because it attempts to normalize policy. And also, by bringing down soaring inflation. This follows unprecedented bond purchases from March 2020 to March 2022. Jonathan Cohn, head of rates trading strategy at Credit Suisse in New York said that the impact of QT will be more evident in places like money markets. He also added that he will be watching the way in which it proceeds through deposits and through the withdrawal of liquidity. The Fed is pulling back at a time when the Treasury market was already struggling with periods of choppy trading. While the banks face greater regulatory constraints, U.S. government debt issuance has soared.
Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia said that they could see a little bit weaker liquidity in the Treasury market. Henceforth, there is no opportunity to sell bonds from dealer balance sheets on to the Fed. Banks have reduced bond purchases. This is after being burned by losses. Foreign investors have also shown less interest in U.S. debt, because of the rise in hedging costs. Gennadiy Goldberg, senior U.S. rates strategist at TD Securities in New York said that the risk is the market is unable to absorb the additional supply. And big adjustment must be done in valuations.
Credit Suisse’s Cohn said that, they think other determinants will be just as or even more important for thinking about the direction of yields. The last time the Fed reduced its balance sheet it ended badly. There is also excess liquidity in the form of bank reserves and cash, that are lent into the Fed’s reverse repurchase facility. Bank reserves stand at $3.62 trillion. The Fed is also taking time to ramp up to its monthly cap of $95 billion in bonds. Subadra Rajappa, head of U.S. rates strategy at Societe Generale in New York said that it is going to be very gradual.

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