The balance sheet of the US Federal Reserve is continuously declining. This exacerbates low liquidity and high volatility in the $20 trillion US Treasury bond market. Economists are now wondering what the Fed will do to straighten things out.

The Fed is short of liquidity - who will be sacrificed?

The last five months of quantitative tightening (QT) for the Fed is designed to drain the stimulus that was pumped into the economy during the COVID-19 pandemic. Nevertheless, the Fed's balance sheet is still large, reaching $8.7 trillion, which, admittedly, is not much lower than the peak value of almost $9 trillion.

To correct this situation, the Fed planned to release about $95 billion from the balance sheet in September, which would signal to markets that the central bank would no longer reinvest the principal and interest payments received from maturing US Treasuries and mortgage-backed securities.

However, amid the Fed's aggressive rate hike cycle, there are now liquidity and volatility concerns for US Treasuries. And although they can also be attributed to long-standing structural problems arising from US banking rules created after the global financial crisis of 2008, and more precisely, after the Clinton confluence of investment and credit banks in 1999, now the scale of the problem has attracted the attention of all macroanalysts.

Yes, we see the obvious: the Fed is determined to cut its balance sheet. But at the same time, some analysts still believe that if the problems facing investors get out of control, the Fed will simply stop the process... without achieving the final goals.

With this approach, experts have doubts whether the Fed will be able to keep a firm hand in principle and not succumb to criticism from the Senate and large industrialists, who are already ready to cry out about a drowning economy.

Of course, if bond volatility continues to rise, we could very well see a repeat of the events of March 2020, with the Fed eventually being forced to end QT and buy large amounts of Treasuries. And this opinion is becoming more and more popular, overturning the bearish sentiment.

So, UBS economists confirmed this version last month, saying that the Fed's balance sheet will face a number of complications until 2023, which will prompt the Fed to sharply slow or completely stop the balance sheet reduction as early as the middle of next year.

Bonds are not in demand

Let me remind you that a key indicator that is monitored by investors and even traders who are not directly involved in the bond market is the liquidity premium of outstanding treasury bonds or new issues compared to retired treasury bills. The latter are older treasury bills that include most of the total debt outstanding, but represent only about 25% of the total debt outstanding.

Current treasury bonds typically carry a higher premium than over-the-counter bonds during periods of market stress. For example, 10-year premiums on current deals compared to their out-of-turn counterparts are the highest since at least 2015.

So, it seems that high premiums, combined with the standard reliability of government bonds as an instrument, are no longer of interest to savers.

Thus, Morgan Stanley notes in a research note that liquidity outside circulation suffered the most in the sector of 10-year US bonds, followed by 20-year and 30-year bonds, as well as five-year bonds.

It is also difficult for fund managers to explain this phenomenon: "There is some indirect function that QT exacerbates the lack of liquidity... There is a derivative effect when you have such a large buyer - we are talking about 40% of the market - it not only leaves, but becomes a net seller.

Of course, this is partly a direct consequence of the inverted yield curve, which makes two-year bonds more desirable than longer positions. The direct reason for this situation is the firm belief of the markets that inflation will last no longer than 2023. But I also think that this is the influence of the bulls.

After all, bonds were not a popular tool during the maximum lockdown. And now, while the market is still hot (and it is hot), investors are still trying to make the most of the stock, cryptocurrency and other markets, leaving bonds as a last resort. Simply put, no one needs long bonds now, because the market offers many other interesting instruments.

Wide bid and ask spreads

We are now seeing how low liquidity has increased volatility in the Treasury market and widened bid-ask spreads, meaning that participants are paying slightly more to buy and get less to sell a security than before, which is also not conducive to turnover.

Thus, the ICE BofAML MOVE index, an indicator of the expected volatility of US Treasuries, was 128.44 last Friday. This level is already close to allowing Treasuries to move up an average of eight basis points over the next month. Now compare that to the usual: Over the past decade, Treasuries have averaged two to three basis points in movement.

This is not today's problem.

Those who follow the bond market, if only as an indicator, know that liquidity problems in the Treasury securities market have been popping up here and there for years, which was due to financial sector rules created after 2008. Dealers typically maintain market liquidity by intermediating customer transactions, for example by moving customer sales orders into inventory when customers are not available.

And while the Treasury market has risen sharply since 2008, briefly burying all these problems under the backwaters, the level of dealer intermediation has remained low. And now it is obvious that the new rules have made trading in the Treasury market less attractive for dealers.

Now I even wonder if the surge in such speculative instruments as cryptocurrencies, memes or SPACs was not just an attempt to quickly and easily put into circulation super-large sums of cash? Maybe the problem of liquidity of bonds already then made itself felt?

However, the Fed has so far been unable to do anything to address the issue of mediation. And there's a growing feeling that it can't.

The central bank is only able to enter the market and buy bonds when the market breaks away from fundamentals, as happened during the pandemic, which could mean the end of quantitative easing, analysts said.

At the moment, very few market participants are willing to bet that the Fed will end or suspend QT – yet a significant component of inflation is tied to liquidity gained from quantitative easing (QE) during the pandemic era.

We must understand that part of the $5 trillion of all kinds of aid put into circulation during the pandemic period stimulates the current inflation. It becomes obvious that the solution to the problem of inflation must include a reduction in the balance sheet... But it seems that the Fed has a problem with the latter.

This seems like nonsense: the regulator, which injected trillions of dollars of state support into the economy, now cannot find a use for them. Because in fact, these amounts can be safely neutralized by immobilizing them in long-term investments (or bonds, yes). But this is not happening: free funds continue to walk around the speculative markets, as traders wanted to spit on the promise of "heavenly car" and crises combined.

And now the Fed is in a dilemma: if it cuts the SOMA (System Open Market Account) portfolio too much, the market will collapse. And first of all it will be the bond market. It simply will not have time to absorb the excess liquidity of other sectors. And since bonds are an indicator for the entire market as a whole, this threatens a strange collapse: there will be money, but due to technical indicators, the markets will be empty.

If the Fed does not keep the evil mask on its face, we will be stuck in inflation for a long time. And here it is also difficult to draw a picture of the future: either free money will still exhaust itself due to rising prices, or the rich will be forced to pay huge taxes on investment transactions ... and this, by the way, is also quite an option. It really could turn a system error into a huge plus for the economy: more taxes, fewer transactions - isn't that ideal? Of course, the rich [also crying] will be dissatisfied, but someone needs to be sacrificed. Either it will be an army of retail traders, or it will be [workers and countrymen] employed in the real sector. And something tells me that this time they will drown the second. Bet?