Analysis: Nagging U.S. Treasury Liquidity Problems Raise Fed Balance Sheet Predicament

• The U.S. Federal Reserve's ongoing balance sheet drawdown has exacerbated low liquidity and high volatility in the $20-Trn U.S. Treasury debt market, raising questions on whether the Fed needs to re-think this strategy.
• Intended to drain stimulus pumped into the economy during the COVID-19 pandemic, the Fed's quantitative tightening (QT), as it is commonly referred to, has been running for the last five months. The Fed's balance sheet though remains at a lofty $8.7Trn, down modestly from a peak of nearly $9Trn.
• Since September, the Fed has planned to allow $95Bn in balance sheet runoff, meaning it would no longer reinvest the principal and interest payments received from maturing U.S. Treasuries and mortgage-backed securities.
• However, there are underlying liquidity and volatility problems in U.S. Treasuries amid the Fed's aggressive rate hike cycle. The problems can also be traced to long-running structural issues arising from U.S. banking regulations created in the aftermath of the 2008 global financial crisis.
• While the Fed is determined to reduce its balance sheet, if the problems facing investors get out of control, some analysts said the Fed may just halt or suspend it.
• UBS economists said last month the Fed's balance sheet runoff will face several complications through 2023, prompting the Fed to sharply slow or fully stop balance sheet reduction sometime around June 2023.

(Source: Reuters)