The Federal Reserve plans to resume asset purchases early next year to help temper investor unease about the U.S. government’s financing challenges.
This comes after the Federal Reserve concluded its three-year run of quantitative tightening and signaled that the central bank will resume being a major buyer of U.S. Treasuries.
Chair Jerome Powell commented, “At a certain point, you’ll want . . . reserves to start gradually growing to keep up with the size of the banking system and the size of the economy.”
Marco Casiraghi of Evercore ISI also noted that the Fed would begin buying Treasuries again in the first quarter of next year, aiming to expand its balance sheet by March at the latest.
The Federal Reserve’s quantitative tightening program, which began in 2022, aimed to reduce the central bank’s holdings of Treasury and mortgage-backed securities accumulated during pandemic-era quantitative easing. QT has been steadily reducing Fed holdings since that peak.
Nearly all of the QT that has transpired this far has taken the form of eliminating the excess of cash that the firms eligible to do business with the Fed had deposited in the reverse repo facility, which peaked at $2.6 trillion at the end of 2022, and is now experiencing a nearly complete lack of activity.
From now on, the Fed will move forward with a balance sheet that’s considerably more significant than the $4.2 trillion level seen at the onset of the COVID-19 pandemic.
U.S. markets have eased their anxiety about the country’s supply pressures
Casiraghi projected that the Fed would purchase around $35 billion worth of Treasuries per month, translating into a $20 billion monthly expansion of its $6.6 trillion balance sheet. He also noted the Fed will drop some of its mortgage-backed assets.
The Fed’s actions are intended to restore confidence among investors uneasy about the government’s debt sustainability. So far, markets have calmed somewhat, with traders expecting the Fed to end its quantitative tightening. Fund managers were also optimistic that the U.S. deficit, currently at 6% of GDP, may shrink.
Mark Cabana, head of U.S. rates strategy at Bank of America, even noted that markets seem far less anxious about supply pressures than before. He remarked, “Concerns about the deficit worsening have been cooled due to strong tariff revenues, and the expectation that the Fed will soon start buying [government debt].”
The 10-year U.S. Treasury yield, a bellwether for global borrowing, has already dropped from 4.8% in January to under 4.1%, thanks to a sustained rally since the summer, primarily driven by expectations that the Fed will soon lower rates.
Casiraghi asserts that the Fed does not intend to extend QT at the moment
The yield spread between U.S. 10-year Treasuries and interest swaps of the same maturity has narrowed sharply since April’s peak, dropping to roughly 0.16 percentage points. Typically, bond yields and swap rates remain closely aligned, as they both reflect expectations for future interest rates. But in the U.S. and U.K., yields have outpaced swaps this year as investors demanded extra yield to take on growing government debt.
Yields on 30-year U.S. bonds are now just one percentage point higher than on 2-year notes, down from over 1.3 in September. Meanwhile, the gap between 10-year U.K. government bond yields and swap rates has narrowed to roughly 0.25 percentage points from almost 0.4 percentage points in April.
The Fed’s decision to call off its quantitative tightening path came along when signs appeared that the central bank’s attempt to lift liquidity was destabilizing short-term funding markets
The purchases indicate that banks have more than sufficient reserves. To put this into perspective, in the past, quantitative easing engaged trillions of dollars in debt buys during downturns. Casiraghi even explained that quantitative easing is designed to boost liquidity aggressively during times of crisis.
In contrast, the Fed’s goal now is simply to ensure the system has enough reserves to implement policy effectively.
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