Author: Mike Dolan
LONDON (Reuters) – There is always a balance.
Battered bond markets are frantically repricing government borrowing to levels not seen in decades, raising fears that the rout could undermine broader markets and even economies.
The root causes of the bond tumult are well-documented: investor concerns about sticky US inflation, Federal Reserve interest rates and debt rising as a new US presidential administration takes office.
But worried investors seem to forget that central banks still have an incredibly powerful tool at their disposal: their balance sheets.
Central banks have a mandate to preserve financial stability. If they feel the markets are unduly jittery, they can mobilize their theoretically infinite balance sheets at any time.
While several major central banks have written debt off their books and in some cases sold it outright in the past two years, policymakers can always step back if necessary.
We’ve seen that before. The Bank of England temporarily reversed its balance sheet reduction to successfully stabilize the gilt market in late 2022. And the Fed did the same during regional bank jitters in March 2023.
What’s more, the Fed and other central banks already appear poised to halt their balance sheet drain — or “quantitative tightening” (QT) — early this year. Analysts expect roughly half a trillion more dollars to go to the US before the program ends.
This outflow has yet to cause a shortfall in U.S. bank reserves or disrupt broader money market liquidity, according to the New York Fed’s new monitoring tool.
For reference, the Fed’s $6.9 trillion balance sheet — down from a peak of over $9 trillion in 2022 — now represents about 24% of nominal US gross domestic product. That’s 10 percentage points off the peak, but remarkably after all the pandemic interventions, it’s actually below what it was 10 years ago.
BALANCING BALANCING?
The likely end of QT this year partially frees up the decks for emergency interventions, if deemed necessary.
It should also act as a salve for bonds if things get out of hand.
Former New York Fed chief Bill Dudley noted last year that once a sustainable balance sheet level is found, holdings should be concentrated in bills and short-term paper. As all necessary interventions would likely occur eventually and could be easily financed by maturing bills, this would mean that the overall size of the balance sheet would not change during the bailout.
However, the size of the central bank’s balance sheet has clearly become politically sensitive.
And the post-pandemic consensus among monetary policy makers and governments is that the past 15 years of balance sheet expansion should be consigned to history, with every effort to keep the issues of monetary policy and financial stability separate.
That may be easier said than done if things go sideways. And while markets could become even more volatile without prompting central bank action, the knowledge that this tool is available should remain a potentially powerful hedge.
PRE-GFC VISTA
Although the minutes of the Federal Open Market Committee meeting show that the Fed did not discuss much about the balance sheet last month, other than a technical change to the reverse repo window, policymakers noted that the market was pushing back on its assumptions about when QT would end.
Some Fed officials also addressed the balance sheet issue in light of this year’s relentless bond selloff.
Intriguingly, Kansas City Fed chief Jeff Schmid said last week that the size of the balance sheet is still putting downward pressure on market borrowing costs, raising the question of where bond yields might be if QT is not lifted.
Schmid estimated that 10-year yields, which are near 4.8% for the first time in 14 months, would be somewhere “between 50 and 100 basis points lower” if the Fed’s balance sheet were significantly smaller.
It’s also useful to look at the so-called futures premium in the Treasury market, which has climbed back toward levels seen before the Fed’s balance sheet was first expanded around the 2008 banking meltdown.
The New York Fed’s estimate of the term premium on 10-year Treasury yields is back as high as 65 basis points for the first time since 2014. But that’s far less than the 190 bps average seen in the 20 years before 2008.
While “counterfactuals” are hard to prove, it’s fair to say that a hefty balance sheet continues to add weight. It is also certain that the Fed and other central banks will not be giving up their right to use these powerful tools anytime soon.
The opinions expressed here are those of the author, a Reuters columnist.
(Mike Dolan; Editing by Jamie Freed)
