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Next Fed Action Will Test Market Stability

The Fed’s resolve to fight inflation could be tested even before the economy is hit by a recession due to dislocations in certain corners of the market that are not well understood. This is about more than just a bear market in stocks or a cryptocurrency implosion. Rather, it is the backbone that keeps markets running smoothly and facilitates the flow of money in and out of the financial system. When it cracked in the past, the Fed was forced to adjust its course, often with little warning.

A look at the episodes of the past that led to the fed to modify its policy or take emergency measures reveals that disturbances in the proper functioning of money markets and the US government debt market have been the main triggers. Concern about these markets, which are essential to the stability of the financial system, will only grow when the fed begin in a few weeks to withdraw liquidity from the markets by reducing its balance of US$8.9 billion.

The problem is that what used to be rare is becoming more common. In 2019, the repurchase agreement market froze after months of declining bank reserves as the fed liquidated its Treasury holdings. Then in March 2020, when the pandemic sent businesses, consumers and investors into a panic in a race for cash, liquidity in the then $17 billion market for CTS, new withdrawal at 100%: They promulgate a law that allows the total availability of moneyTreasury suddenly disappeared. The fed responded with unlimited purchases of bonds They didn’t stop until this year. Since then, the Treasury market has grown to $23 billion.

Starting next month, the fed will begin to reduce its holdings bondsconsisting almost exclusively of bonds Treasury and mortgage-backed securities. Although central bankers hope that the reduction will not disrupt the functioning of the market, it will come along with what are expected to be significant increases in interest rates in the next two central bank policy meetings to bring the economy back under control. inflation galloping.

The risks are greater now given the great presence of the fed in the bond market as its role as a provider of liquidity has grown exponentially, with its balance sheet more than doubling since the end of 2019. In addition, the fed it is not alone in withdrawing stimuli. The European Central Bank, the Bank of England and the Reserve Bank of Australia are also ending quantitative easing programs. During the decline of the balance of the fed in 2017-2019, the ECB continued to buy bonds.

Two things can go wrong when fed start liquidating your portfolio bonds. One is that you also need to balance your liabilities, part of which are bank reserves. While these are ample now, banks must constantly build up enough reserves to meet increasingly stringent regulatory requirements. But even when these reserves are sufficient, they are not equally distributed among lenders. It was this imbalance that caused the repurchase agreement market to dominate in 2019. Assuming the Fed’s balance sheet shrinks by about $500 billion this year, bank reserves could shrink by about $1 billion by the end of the year. from $3.3 billion today, according to Barclays Capital money market strategist Joseph Abate.

Just three months before repo rates shot into double digits in September 2019, officials at the fed they assured investors that reserves were plentiful and that balance sheet reduction would continue to work on autopilot. Then, on September 17, repo rates rose to 10%, forcing the fed to backtrack, prematurely end the balance sheet liquidation, and buy bonds of the Treasury. At the time, some rate strategists even suggested that the fed it would have to establish some kind of permanent quantitative easing to manage the liquidity of the market.

The Treasury market would not be immune to dislocations. purchases of the fed have helped improve liquidity in an unloved segment of the market: bonds of the Treasury that no longer have the reference maturities.

Not that the fed have not learned the lesson. There is now a permanent repurchase agreement facility to address emergency cash needs and help mitigate potential dislocations. And the fed has been taking a cautious approach toward reducing its balance sheet this time around, largely due to the troubled experience of 2019. fedJerome Powell, promised to slow or stop the slide in the balance sheet before reserves fall below levels considered “ample”.

But no one knows what those levels are and how quickly they would drop. like the same fed As she admitted, she is not sure how her actions will impact liquidity or how the permanent instrument of repurchase agreements, which has not been tested, will be used. “I can’t tell you how this will actually work”Federal Reserve Bank of Chicago President Charles Evans told Bloomberg News on May 18.

What is certain is that once the fed start shrinking your balance sheet while continuing to raise rates in successive half-point hikes this summer, there will be an unprecedented scale of monetary tightening. If the backbone of the financial system begins to crack, expect the Federal Reserve to alter course.

Source: Elcomercio

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