Analysis: Aggressive Fed Balance Sheet Runoff Could Shake Flattened Yield Curve

An eagle tops the facade of the U.S. Federal Reserve Building in Washington, July 31, 2013. REUTERS/Jonathan Ernst/

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April 7 (Reuters) – Investors are weighing whether a relatively rapid reduction in the Federal Reserve’s balance sheet could boost the flattening of the Treasury’s yield curve, which has raised warnings of a potential recession.

Minutes from the central bank’s March meeting showed Wednesday that the Fed intended to start shrinking its balance sheet by $9 trillion in the coming months, possibly reducing its holdings of Treasuries and asset-backed securities. to mortgages of $95 billion a month – a faster clip than when it undertook quantitative tightening from 2017 to 2019. read more

The pace of the Fed’s run-off could help push yields on longer-dated Treasuries above those of shorter-dated ones, depending on how the Treasury restructures its debt issuances to offset the decline in Fed purchases.

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This could relieve some market participants, who have been concerned about inversions in various parts of the yield curve in recent weeks, including the closely watched spread between two-year and 10-year rates.

While such a reversal has been a harbinger of past recessions, analysts are split on whether the signal can be distorted this time around, with some saying the Fed’s unprecedented bond buying is keeping longer-term returns lower than they otherwise would be. Read more

A brief foray into negative territory could reduce worries about a recession and reinforce the idea that the reversal was tied to Fed bond holdings.

“That should accentuate the curve. They are obviously well aware that a flat curve is of great concern to us as market participants,” said John Luke Tyner, fixed income analyst at Aptus Capital Advisors.

The two-year and 10-year yield curve steepened to 13 basis points on Wednesday, after inverting to minus 10 basis points on Monday. Benchmark 10-year yields hit 2.659%, the highest since March 2019. Two-year yields hit 2.602%, the highest since January 2019.

A steeper yield curve would go against the market consensus. A recent Reuters poll of nearly 60 fixed income strategists showed that no big upside was expected anytime soon for 10-year bonds, leaving the yield curve flat or systematically at risk of another reversal in the course of the coming year. Read more

The yield curve could also steepen if the Fed decides to rely more on balance sheet reduction to tighten financial conditions, which could allow it to be less hawkish on rate hikes. [L1N2UB1UH]

The big question is how much the balance sheet reduction is worth relative to the rate hikes, said Gennadiy Goldberg, interest rate strategist at TD Securities in New York. If the Fed relies more on balance sheet cuts “it could help steepen the curve a little bit, because that’s the start of the curve that has sold off furiously and may start to level off.”

With few signs that the surge in inflation will soon abate, expectations of increasingly hawkish Fed policy have risen on Wall Street in recent weeks, along with worries about its potential consequences. .

Deutsche Bank on Tuesday became the first major bank to forecast a recession, saying a cocktail of geopolitical upheaval and inflation stemming from the war in Ukraine and significant Fed tightening would send the US economy into a slowdown. by next summer and precipitate a 20% equity decline.

Bank analysts expect the Fed to hike rates by 50 basis points in its next three meetings “with balance sheet reduction adding at least another 75 basis points of rate hikes,” according to a report. recent.

Wednesday’s minutes appeared to match those expectations, paving the way for larger interest rate hikes and reinforcing the view that the Fed is dealing with soaring consumer prices. Policymakers raised interest rates by 25 basis points last month, the first increase since 2018.

“This is largely a statement of (the Fed’s) aggressiveness,” said Christopher Alwine, head of the Global Credit team at Vanguard Fixed Income Group. “They’re trying to slow the economy down, and generally the Fed’s pattern is they do that until something breaks, and something usually breaks in the financial markets first.”

Morgan Stanley analysts, meanwhile, said in a recent note that the Fed’s projected estimates exceeded their forecast by $80 billion per month.

“The general tone of the minutes showed much more concern among policymakers about upside risks (to) inflation compared to a relatively more limited discussion about growth and risks to the growth outlook,” they wrote.

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Reporting by Karen Brettell and Davide Barbuscia; Additional reporting by Chuck Mikolajczak; Editing by Ira Iosebashvili & Shri Navaratnam

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