MNI INTERVIEW: Thin Liquidity Complicates Fed Plans To Tighten

Deteriorating liquidity in the USD24 trillion U.S. Treasury market presents a major risk to global financial stability that could force the Federal Reserve to end quantitative tightening before 2024 and complicate its efforts to tamp down inflation, Priya Misra, a member of the Fed’s Treasury Market Practices Group, told MNI.

The Fed is not only raising interest rates at one of the fastest clips in its history, it is also shrinking its balance sheet, which peaked at almost USD9 trillion in April and has since declined to USD8.6 trillion.

“Treasury market liquidity is always important, but it’s more important if you’re dealing with some sort of shock,” said Misra, managing director and head of global rates strategy at TD Securities. “And the shock right now is an unprecedented hiking cycle, which is unprecedented in its speed and the global nature of it.”

Treasury market liquidity has remained poor by many measures, prompting renewed calls for reforms of various sorts, including possible adjustments to the supplementary leverage ratio. Misra is concerned things might deteriorate if the Fed is forced to tighten even more than in the already-hawkish scenario of a 5% peak rate priced in by markets. (See MNI INTERVIEW: Fed’s QT Could Trigger Liquidity Crunch-Rajan)

“We all think the Fed ends hikes sometime in the first half of next year. What if inflation is so sticky that they’re hiking to the end of next year, to a higher level? Does that result in any financial institution or some part of the market (cracking)?” she said.

“It’s not something that is a slow burn, it’s actually something that could become very meaningful in a shock event. If there’s any sort of financial stability issue it could spiral out of control really quickly now.”

HIDING IN PLAIN SIGHT

The UK pension fund debacle is a perfect example of how large, unexpected pockets of vulnerability can hide in plain sight.

“LDIs are an example. I would be shocked if anyone said they saw this coming in this particular sector. It’s a pretty well-regulated industry, they actually did everything right in terms of duration matching and yet they had a problem there,” she said. “People wanted cash but they didn’t have enough cash, all they had was gilts, it wasn’t enough.

“It highlights that vulnerabilities get amplified if liquidity is poor. And you have a shock that we’re all living through. If we had a liquidity problem with the Fed on hold or doing QE we could afford to ignore it.”

Instead, the Fed is doing QT, which Misra thinks it will have to abandon by the time 2023 draws to a close.

“I think QT stops by the end of next year either because we get reserve scarcity or the Fed starts to cut rates,” she said.

Fed staffers say they expect tightening liquidity to be eventually alleviated by a fall in usage of its reverse repo facility, and by a recalibration of bank capital requirements.

But Misra said she’s advising clients who are not able to park their money at the Fed that they need to make sure they have enough liquidity to withstand losses on other holdings.

“If you have corporate bonds or mortgages you might want to also hold some liquid assets. Your liquidity needs are higher because the products you thought might give you liquidity may not,” she said. “Maybe it’s not even Treasuries. Maybe you need to have a higher cash buffer because you can’t even rely on the Treasury market. But if Treasury market liquidity goes down, what happens to the mortgage market, and credit?”