Could the Fed end quantitative tightening in the weeks ahead?
The summer of 2024 may have finally brought increased urgency on the part of the Fed to roll back its tightening stance
THE market turmoil of recent weeks has shifted the probability of a Fed rate cut dramatically from only several weeks ago. Indeed, whereas markets were previously cautious about a rate cut as early as September, by mid-August, markets began to price an equal probability of a 25-basis-point (bp) rate cut as a 50-bp cut in September.
Moreover, the futures market anticipated Fed rate cuts at mid-month that were forecast to reach close to 3.25 per cent by end-2025. The speed of this anticipated cutting cycle exceeds rate cut cycles during the 1994-95 soft landing as well as the 1989 rate cutting cycle leading into the 1990 recession. Only in the 2000, 2007 and 2019 rate-cutting cycles did the Fed move more aggressively than what is being priced currently.
Although markets have moved quickly to price a recessionary outlook by anticipating aggressive rate-cut moves by the Federal Reserve, the same cannot be said with regard to the Fed’s other policy tool – its balance sheet.
Recall, in 2022 as the Fed began raising rates for the first time since the 2020 global pandemic, it simultaneously reversed the pandemic era balance sheet expansion by allowing a portion of the Treasuries it held to mature (“quantitative tightening”) without re-investing them into the US government bond market. This provided a two-pronged policy tightening against the post-pandemic inflationary pressures which were compounded by the stress brought about by Russia’s 2022 invasion of Ukraine.
The first sign that this Fed tightening cycle was maturing was the pause the US central bank instituted after its July 2023 hike. However, the policymaking Open Market Committee continued to allow its balance sheet to shrink over the past year, draining another US$1 trillion from the economy over that period.
The summer of 2024 may have finally brought increased urgency on the part of the Fed to roll back its tightening stance even beyond the growth scare triggered by the weak Institute for Supply Management figures and the rise in unemployment in early August as the demand for US Treasuries at auction has struggled in recent weeks.
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Pandemic era
In industry parlance, the “tails” of recent Treasury auctions have been historically large. In other words, the yield the US Treasury has been forced to pay at auction has been unusually large relative to the pre-auction (“when issued”) yield on the security. The Fed’s response in recent years to such large auction tails has been consistent.
During the pandemic era, tails were modest in size because the Federal Reserve was a dominant buyer of Treasuries in the marketplace. However, once the Fed began raising interest rates and shrinking its own bond buying in 2022, these auction tails began to grow.
Although the Fed continued to raise its policy rates and shrink its balance again in 2023, weak Treasury auctions and their associated tails were not an issue as the American debt ceiling crisis of 2023 prevented the US Treasury from issuing new debt. Instead, the US Treasury could count on most holders of existing debt to simply look to rollover their existing bonds in order to take up auction supply.
Once the debt ceiling was resolved in June 2023 and in light of the nearly US$2 trillion deficits that needed to be funded, Treasury auctions once again began to struggle, culminating in the largest tail in the 30-year Treasury auction in November 2023. Recall, the weak 30-year Treasury auction and a similarly weak 10-year Treasury auction led yields to challenge 5 per cent for the first time since before the 2008-09 global financial crisis.
The response from both the Fed and the Treasury was swift to what it perceived was instability in the US government bond markets. The US Treasury pivoted by reducing its issuance of long-dated Treasuries, turning to short-dated T-bills which could tap the more than US$1 trillion in liquidity deposited at the Fed’s Reverse Repo facility at the time. In concert, the policy setting Open Market Committee then signalled at its December meeting that rate cuts were “likely” in 2024 while simultaneously, Dallas Fed president Lorie Logan laid out the framework for rolling back quantitative tightening to signal this policy response was on the table as well.
As the next Treasury auctions took place in the spring of 2024, American policymakers were once again challenged. This time, primarily in the 10-year Treasury auction, where tails once again challenged their 2023 highs. In response, the US Treasury, once again turned to short-dated auctions to tap the then US$400-500 billion in reverse repo liquidity while the Fed responded by unveiling a “tapering” (slowing) of its quantitative tightening programme to allow the US central bank to re-invest more of its maturing bonds back into the Treasury market.
These moves however, appear to have been insufficient to quell the bond market instability with the auction tails of August 2024 once again challenging the peaks seen not only in April 2024 but also those of October 2023.
End to quantitative tightening
Facing challenging bond auctions and with reverse repo balances dipping below US$300 billion in early August, the US Treasury will likely find it increasingly difficult to replicate its previous strategies to ease pressure in bonds auctions. Instead, this constraint on the US Treasury has the potential to increase the burden that the Federal Reserve bears to avoid instability in the American government bond markets.
Thus, while the debate over when and how much the Fed may be cutting in the autumn is certainly an important debate, investors should not overlook the prospect that the Fed concurrently turns to ending its quantitative tightening programme in the weeks ahead just as it begins its rate-cutting cycle.
For bond investors, the only period that has seen an end to quantitative tightening was in August 2019. Then, the Fed ended the quantitative tightening programme two months earlier than previously communicated while simultaneously beginning a rate-cutting cycle in response to stress in the US money market, not unlike the setup currently.
Following the rate cuts and end to quantitative tightening, unsurprisingly, two-year US yields stabilised, having already fallen meaningfully till end-July, in anticipation of the Fed rate cuts. At longer tenors, US 10-year yields began to rise, steepening the US yield curve into year-end before the onset of the global pandemic took hold in early 2020.
While unclear whether this steepening trend would have continued in the absence of the global pandemic, the 2019 experience provides additional support to our contention that risk-reward in long-dated US Treasury markets is unfavourable for bond investors, suggesting that investors may face higher yields moving into year-end.
Thus, despite the sharp fall in yields recently and growing concerns about an imminent recession in the US, we continue to believe that interest risk is best minimised as this potential two-pronged Fed policy shift unfolds. Instead, a further widening in credit spreads beyond that seen in July and August from their cyclically tight levels would present an attractive risk-reward opportunity for bond investors looking ahead.
In any case, bond investors should be looking to manage interest rate risk pro-actively, given the elevated bond volatility that has emerged and now looks to be a characteristic of the post-pandemic era.
The writer is group chief strategist at Union Bancaire Privee, a private bank and wealth management firm
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