In the coming months a record amount of coupon Treasuries will flood the market even as demand for those securities appears to be faltering. Recent remarks from Chair Powell suggest quantitative tightening will proceed at a pace of $1t a year, double the annual pace of the prior QT. That could imply a process that quickly ramps up to around $700b in Treasuries and $300b in Agency MBS in annual run-off. At the same time, Treasury net issuance is expected to remain historically high at ~$1.5t a year. This implies that non-Fed investors will have to absorb ~$2t in issuance each year for 3 years in the context of rising inflation and rising financing costs from rate hikes. Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers. In this post we preview the coming QT, sketch out potential investor demand, and suggest a material steepening of the curve is likely.
Three Years to Shrink the Balance Sheet
Chair Powell has sketched out the contours of the upcoming QT program through a series of appearances. He noted at a recent Congressional hearing (1:48) that it may take around 3 years to normalize the Fed’s $9t balance sheet. The Fed estimates its “normalized” balance sheet based on its perception of the banking system’s demand for reserves. A conservative estimate based on the pre-pandemic Fed balance sheet size, and taking into account growth in nominal GDP and currency, arrives at a normalized balance sheet of around $6t. This would imply QT at rate of ~$1t a year, roughly twice the annual pace of the prior QT.
Chair Powell suggested at his March press conference that QT would begin in May and look like the prior QT, which began with a ramp up and ended with a ramp down. The Fed’s maturity profile for Treasury coupons is front loaded and for Agency MBS is an estimated $25b a month pace. An aggregate cap that begins at $50b and ramps up to $80b would achieve $3t in QT in around 3 years. The Fed’s Treasury bill holdings are not strictly part of a QE program and may be managed separately. Note that Agency MBS prepayments are expected to be very low in the coming years as borrowers have less incentive to refinance. This may argue for a steady non-binding cap on Agency MBS reinvestments with some outright sales in the third year.
Funding Uncle Sam
Over the next three years the market will have to absorb an unprecedented level of issuance as QT overlaps with historically high net issuance. QT does not change the size of the Treasury market but does change the composition of ownership. By the end of QT Non-Fed investors should hold $2t more Treasuries as Fed holdings decline by $2t. In addition, the overall size of the Treasury market is expected to increase by a projected ~$1.5t in net issuance a year. This projection may be conservative as Congressional spending has a history of increasing. Note that the exact maturity structure of the new issuance is determined at the discretion of Treasury.
Banks and foreigners (and Fed) have been the key marginal investors in Treasuries, but they are unlikely to increase their holdings going forward. Foreign private investors fund their purchases in the FX swap market, where rising borrowing costs from rate hikes are making dollar assets less attractive. Certain large foreign sovereigns may hesitate to further increase dollar exposure out of prudent risk management. With respect to banks, some large banks have indicated a shift in preference from securities to loans due to strengthening loan growth. QT will also mechanically shrink bank balance sheets so banks will no longer need to optimize returns by swapping reserves for Treasures.
Recent fund flow data also suggest waning demand for Treasuries. Data on bond ETF and mutual fund flows show a long streak of inflows has been broken by three straight months of outflows. This may be in part due to multi-decade high inflation readings and rising inflation expectations. Soaring prices across vast swaths of the commodity complex suggest that inflation could remain high and persistent. Bond prices may have to materially reprice to draw new buyers.
The price of any asset is not so much determined by perceived economic fundamentals as by supply and demand. This is particularly the case for safe assets like Treasuries, where vast swaths of issuance is absorbed by investors who are either not interested in returns or highly constrained in their investment options. The remaining discretionary managers live in a post-GFC world where balance sheet is scarce. When balance sheet is scarce, then there is only so much bank credit or repo financing available to fund positions and shape prices.
Anticipation of QT is already widening the spread between Agency MBS and Treasuries, but does not yet appear to affect Treasury prices. The supply and demand dynamics suggest that market may simply be slow to react. In that case, Treasury prices will also have to adjust downward, maybe by a lot.