Fixed-income traders are telling the Federal Reserve that it might end up making a big policy mistake.
And it’s not just rising interest rates they’re talking about.
A more pressing concern has to do with the Fed’s crisis-era bond investments. Since October of last year, the central bank has been steadily reducing its holdings of Treasuries and mortgage-backed bonds. But as the unwind has picked up, unexpected knock-on effects are emerging in overnight lending markets, where demand for short-term cash has been on the rise.
Fed officials, who concluded a two-day meeting Thursday at which they left interest rates unchanged, have previously pooh-poohed the idea that they are to blame and point to various technical factors. Yet a growing number on Wall Street aren’t buying it.
The most vocal critics contend that if the Fed doesn’t slow or stop its unwind, it could end up draining too much money from the banking system, cause volatility to surge across financial markets and undermine its ability to control its rate-setting policy. All of which could eventually seep into the broader lending market and push up borrowing costs -- even if just marginally -- in an economy that some predict will start slowing next year.
“The Fed is in denial,” said Priya Misra, the head of global interest-rate strategy at TD Securities. “If the Fed continues to let its balance-sheet runoff continue, then reserves will begin to become scarce.”
The Fed hasn’t explicitly said when it would stop shrinking its balance sheet. TD’s Misra estimates it will by December 2019, though she wouldn’t be surprised if the runoff ended sooner. If the Fed maintains its current pace through the end of next year, its assets would fall to about $3.7 trillion from $4.1 trillion today (and a high of $4.5 trillion). That’d still be more than the $900 billion it held pre-crisis.
So it’s curious to think that at current balance-sheet levels, the U.S. banking system could be facing a problem of not having enough cash. And the mechanics of what Misra and others describe aren’t easy to understand.
But to oversimplify, the argument essentially goes like this: The Fed’s bond buying, or quantitative easing, pumped trillions of dollars into the banking system to support the economy after the financial crisis. (The Fed bought bonds from banks and paid for them by crediting their reserves.) Now, with the economy on solid ground, that money is effectively being sucked out as the Fed reverses that policy. Currently, the Fed is paring its bond holdings by a maximum of $50 billion a month.
The trouble is, post-crisis rules enacted to curb risk-taking, like Dodd-Frank and Basel III, have prompted banks to use much of those same reserves -- upwards of $2 trillion worth -- to meet the more stringent requirements. It’s those forces that are, in effect, creating the scarcity of reserves that has banks -- mainly the smaller ones at this point -- scrambling for short-term dollar funding. Since the Fed started shrinking its assets, reserves have fallen by more than a half-trillion dollars, according to Fed data from Barclays.