From Fed Guy, March 21:
In the coming months a record amount of coupon Treasuries will flood the market even as demand for those securities appears to be faltering. Recent remarks from Chair Powell suggest quantitative tightening will proceed at a pace of $1t a year, double the annual pace of the prior QT. That could imply a process that quickly ramps up to around $700b in Treasuries and $300b in Agency MBS in annual run-off. At the same time, Treasury net issuance is expected to remain historically high at ~$1.5t a year. This implies that non-Fed investors will have to absorb ~$2t in issuance each year for 3 years in the context of rising inflation and rising financing costs from rate hikes. Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers. In this post we preview the coming QT, sketch out potential investor demand, and suggest a material steepening of the curve is likely.
Three Years to Shrink the Balance Sheet
Chair Powell has sketched out the contours of the upcoming QT program through a series of appearances. He noted at a recent Congressional hearing (1:48) that it may take around 3 years to normalize the Fed’s $9t balance sheet. The Fed estimates its “normalized” balance sheet based on its perception of the banking system’s demand for reserves. A conservative estimate based on the pre-pandemic Fed balance sheet size, and taking into account growth in nominal GDP and currency, arrives at a normalized balance sheet of around $6t. This would imply QT at rate of ~$1t a year, roughly twice the annual pace of the prior QT.
A decline from $9t to $6t over 3 years implies $1t a year in QT
Chair Powell suggested at his March press conference that QT would begin in May and look like the prior QT, which began with a ramp up and ended with a ramp down. The Fed’s maturity profile for Treasury coupons is front loaded and for Agency MBS is an estimated $25b a month pace. An aggregate cap that begins at $50b and ramps up to $80b would achieve $3t in QT in around 3 years. The Fed’s Treasury bill holdings are not strictly part of a QE program and may be managed separately. Note that Agency MBS prepayments are expected to be very low in the coming years as borrowers have less incentive to refinance. This may argue for a steady non-binding cap on Agency MBS reinvestments with some outright sales in the third year.
Funding Uncle Sam
Over the next three years the market will have to absorb an unprecedented level of issuance as QT overlaps with historically high net issuance.....
....MUCH MORE
Previously linked from Fed Guy, March 7:
