The U.S. Federal Reserve has doubled the pace at which it is emptying its nearly $9-trillion bond portfolio, now shedding its holdings at a rate of $95 billion a month.

As a result, bond traders are having a harder time closing deals, with the gap between asked and bid prices further apart than at any time since May 2020, according to a study by Bank of America.

A recent Morgan Stanley research report also found that most treasury bonds are harder to sell now than at any time since spring 2020.

A lack of liquidity sparks volatility and sudden lurches in price have become common, the Financial Times reported.

A key index of volatility in the treasury securities market has climbed back to its March 2020 level, when COVID-related lockdowns began.

As the Fed dumps its treasury bonds back into the market, it could create a “cascading effect,” Scott Skyrm, a repo trader at Curvature Securities, warned in an FT interview.

Potential bond buyers may halt bond purchases to see how low prices might fall, allowing bonds to pile up on the market and leaving the U.S. government unable to raise enough money to meet its obligations— especially as banks pull out of the market at quarter-end or year-end to tidy their balance sheets, the FT said.

Because of the Fed’s policy shift, “we could have a problem of liquidity in the banking system,” Viral Acharya, an economist at New York University, told The New York Times.

Strain in the treasury bond market is “arguably one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004 to 2007,” he added.

The NYT cited two similar episodes that flummoxed bonds when the Fed sought to shrink its balance sheet, a process known as “quantitative tightening.”

In 2019, the “repo” market, in which banks make short-term loans to each other using treasury securities as collateral, seized up. 

In 2020, as the COVID War set in, firms sold treasuries to raise cash, clogging the bond market.

Both crises resulted from the Fed’s tightening its bond portfolio, Acharya and a group of economists argued in a recent study, and in those two instances the Fed had to step in to prevent a collapse.

When the Fed increases its bond purchases, bank deposits and lines of credit grow, they said. However, when the Fed shrinks its portfolio, banks do not reduce their commitments proportionately.

Then, if the economy is stressed, more businesses and individuals rush to tap their bank accounts and lines of credit and there may not be enough cash or room in banks’ lending portfolios to satisfy demand.

The paper “echoes our long-standing fear that quantitative tightening may have more effects than central banks will fess up to,” CrossBorder Capital CEO Michael Howell told the FT.

TRENDPOST: Even the Fed is unsure of its policy’s impact. “I would stress how uncertain the effect is of shrinking the [Fed’s] balance sheet,” Fed chair Jerome Powell told a May press briefing, although “by all assessments the markets should be able to absorb this.”

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