Photo by Anna Moneymaker/Getty Images
- The Fed's massive quantitative tightening campaign has had limited effect on the market.
- That's as private sector participants have taken over its role in the Treasury market.
- But banking reserves are still at risk if money market funds stop buying T-bills.
Since the Federal Reserve began cutting down the size of its balance sheet last year, the central bank has allowed about $1 trillion of its debt holdings to run off, but it's so-called quantitative tightening program hasn't rattled the market the way many feared it would.
Where once the Fed's portfolio held around $8.4 trillion in assets, the institution's System Open Market Account now shows that this has fallen to just under $7.4 trillion.
These balance sheet reduction efforts are more commonly known as quantitative tightening, and are a strategy deployed by the central bank to drain excess liquidity from markets.
Though usually overshadowed by interest rate hikes, this alternative approach to fighting inflation works by allowing the Fed's bond asset holdings to mature without reinvesting the proceeds. While the central bank isn't selling bonds outright, running off its balance sheet has a similar effect of reducing liquidity by removing a large buyer from the market.
But since its June 2022 implementation, QT has fueled market concern, given the history of previous balance sheet reductions. According to Bloomberg, a 2019 tightening episode went awry when it led to drained banking reserves.
The Fed's debt runoff also removes it as a significant participant in the Treasury market, with commentators speculating that this would cause a surge in yields and adversely impact equities.
Though yields have climbed in recent months — some of which is on account of interest rate hikes — the overall impact of QT on the marketplace has been limited so far.
Even as the Fed has freed its balance sheet of $60 billion in Treasury assets, and $35 billion in mortgage-backed securities each month, banking reserves have generally held steady, and Treasury markets have found ample buyers among money market funds and private traders.
But according to a St. Louis Fed research paper from late August, adverse effects on banking liquidity could still be around the corner, as money market fund participation in recent T-bill auctions has begun flattening out.
This puts more pressure on lenders to jump into the bond market, burdening their reserves.
"So as the Fed continues with QT-II, it will need to evaluate when to slow and stop redemptions to avoid draining too many reserves from the banking system and cause undo financial stress," the note from the St. Louis Fed said.