The Federal Reserve hopes to pull off the wind-down of its massive balance sheet with minimal market impact, but even a slow withdrawal may increase strains in a crucial section of the bond market.
Any reduction in the U.S. central bank’s balance sheet could make it harder for banks and investors to borrow certain Treasuries in the repurchase agreement market, making it more difficult and expensive to bet on or protect against interest rate increases.
The Fed is widely expected to announce on Wednesday that it will begin paring its $4.5 trillion balance sheet, likely beginning this year.
Banks and investors have benefited from having access to the Fed’s expansive bond inventory for specific issues that can otherwise be hard to come by, but the Fed will soon have fewer bonds to lend.
These loans typically total between $100 billion and $200 billion per day, with demand at month-end and year-end even higher. The operation helps the Fed set a floor on interest rates and provides Treasuries to banks and investors when they are in high demand.
This operation typically sees between $20 billion and $30 billion in loans per day. On some days, demand for certain issues exceeds the amount of those bonds the Fed holds.
By paring its holdings the Fed may make it harder to acquire highly sought after bonds and reduce liquidity in the funding markets, sparking greater market volatility and making it more expensive to short Treasuries.
The Fed’s wind-down could also create an uptick in the number of loans that are not settled on time, a problem that has worried regulators including the New York Fed in the past.
Reference: Reuters
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