MNI INTERVIEW: Fed Says Market Strains Could Ramp Up QT Effect

Strains in the U.S. Treasury market and risk averse traders could complicate the central bank's plans to reduce its balance sheet by amplifying the effect of those reductions on financial markets and raising interest rates more than anticipated, the author of a new Atlanta Fed paper told MNI.

Bin Wei of the Atlanta Fed said in an interview Friday risk aversion amongst traders as the central bank pulls back from the Treasury market and adds additional supply to the market could mean this round of "quantitative tightening" could have a larger impact.

A passive roll off of USD2.2 trillion of the Fed's holdings of U.S. Treasury bonds over the next three years would have the equivalent impact of immediately increasing the short-term federal funds policy rate by about 0.29 percentage points but 74 basis points during turbulent periods, said Wei. "This estimate is based on the assumption of normal market conditions and the 29 basis points is not that big."

In other scenarios with, Wei estimates QT could be equivalent to a nearly 100-basis-point increase.

Without making a clear call which scenario the market is in or headed toward, Wei suggested looking at Treasury volatility. "If recent volatility is greater than the average volatility by 40% then that means my turbulence crisis scenario is more appropriate," which would equate to nearly three typical rate increases, or about 0.74ppts.

"This risk aversion is an abstract way to basically say that arbitrageurs have limited capital and have limited risk bearing capacity," he said. "When they are reluctant to be the marginal investors that's when the market becomes even more segmented."

MARKET TURMOIL

Unlike the relatively calm conditions that prevailed in 2017 when the Fed last reduced its balance sheet, this round of QT is coming as uncertainty about the economy, increases in Fed short-term interest rates, and other factors have strained the key market for Treasuries.

In "normal times," defined as average market conditions in the last two decades in which 10-year Treasury volatility was about 1.2%, QT would have a smaller impact," he said. But in "crisis times" risk aversion would increase and volatility around Treasury yields would increase substantially.

"The key insights of the model is that sometimes the Treasury market can become segmented and when the Treasury market becomes segmented then the arbitrageurs will become marginal investors and not trade actively," he said. "So, whatever the impact is of these Treasuries put to the public by the Fed, the effect generally will be larger then."

Treasury officials and ex-Fed officials have said the Treasury market is in need of reform and a higher level of base volatility could be in store for the market if marginal buyers step to the sidelines. (See: MNI INTERVIEW: Treasury Market Reforms To Ramp Up-Liang)

LIQUIDITY

Still, the Atlanta Fed paper abstracts away issues of liquidity, something Kansas City Fed researchers in the past have pointed to potentially having a larger impact on interest rates during QT than QE.

"In reality there could be some liquidity problem outside of the model," Wei said about his paper. "If market conditions deteriorate, this can cause liquidity of the Treasury markets to deteriorate or increase the strains in the treasury market."