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What market watchers are most worried about as the Fed’s balance sheet shrinks is something called liquidity — trader jargon for the ease of buying and selling a financial asset.
When markets are liquid, money flows freely and easily, and investors can buy and sell a financial asset — in this case, Treasuries — at a stable price with little trouble. Illiquidity, on the other hand, is like a blocked water pipe; it’s hard to push anything through, and what does get past the blockage comes in spurts, with prices moving sharply higher or lower as trades fail to be fulfilled in a predictable way.
Since June 2021, the Fed has been letting a small number of bonds mature without being replaced. Starting this month, the Fed will allow up to $60 billion of Treasuries and $35 billion of mortgage bonds to roll off its balance sheet as the debts come due, twice as much as the past three months.
As the Fed backs away, it’s not clear who will fill the void. And even if new buyers for bonds can be found, the reduction in demand caused by the Fed’s exit is raising fears among traders of volatility that could make future market disturbances worse.
Measures of price volatility are already elevated, and liquidity is the worst it has been since the pandemic-induced sell-off in early 2020, said Subadra Rajappa, an interest rate strategist at Société Générale. “The Fed doesn’t want to find itself in that situation again,” she said. Last week, some traders pointed to the ramping up of Q.T., combined with comments by Fed officials about rate increases, to explain large swings in Treasury prices.
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