Goldman Sachs: Fed’s QT fueling Treasury volatility, hurting liquidity – Bloomberg

“A reduction in the size of the Federal Reserve’s balance sheet could hurt liquidity within the Treasury market, boost volatility and affect how different parts of the U.S. rates market are valued relative to one another, according to Goldman Sachs Group Inc,” per Bloomberg’s latest analytical piece published during Wednesday’s Asian session.

The descriptive reading also quotes Praveen Korapaty follows remarks from Citigroup Inc. who previously said that the process of so-called quantitative tightening -- which is widely expected to follow on the heels of the central bank’s first interest rate increases later this year -- could spark a return of arbitrage opportunities for traders within U.S. interest-rate markets.

“QT is likely to widen the gap between pricing of the most-traded benchmark securities and other, older securities,” Goldman Sachs (GS) adds, “and also to tighten the gap between Treasury yields and swap rates at the shorter-end of the yield curve.”

Bloomberg also said, “The bank’s strategists also expect bigger yield gaps between futures and cash securities and “higher yield dispersion metrics,” they said in a note to clients Tuesday.”

Additional quotes from Bloomberg

Meanwhile, the depletion of excess reserves within the system that stems from a reduction in the Fed’s bond holdings could result in upward pressure on short-term rates, such as the effective fed funds rate and Treasury bill yields, although those moves could be more pronounced in 2023 than in 2022.

The Fed is planning to wind down its buying of Treasuries by March, completing a process that market observers refer to as tapering, and could start shedding its holdings by attrition later this year. 

Fed officials, who are currently paving the way for a widely expected interest-rate hike in March, have yet to announce specific plans for balance-sheet reduction, but they did release a set of principles alongside the authority’s most policy decision indicating that it is looking to embrace the broad model it used last time it engaged in QT back in 2017-2019. 

Projections are most sensitive to the assumption that ‘levered investors will, over time, replace the Fed as the marginal buyer of USTs.’ Strategists don’t expect QT to ‘materially affect’ cross-currency bases.

Their projections are based on an assumption that the Fed will announce runoff plans in June, quickly ramp it up to a pace of around $100 billion per month and ultimately shrink the balance sheet by between $2.2 trillion to $2.7 trillion over a period of two to two-and-a-half years.