Views on Fixed income strategy: Fed balance sheet back to expansion by Dario Messi, Head of Fixed Income Analyst, Julius Baer
Below the Views on Fixed income strategy: Fed balance sheet back to expansion by Dario Messi, Head of Fixed Income Analyst, Julius Baer
The Fed is set to resume balance sheet expansion just days after officially ending quantitative tightening (QT) – not as a policy pivot, but as a logical next step under its ample-reserves framework. Recent repo market volatility signalled that reserves are nearing the lower bound for stable rate transmission, with bank reserves falling toward 9% of GDP. To address this, the Fed announced flexible reserve management purchases starting with around USD40bn monthly, focused on short-term securities. This is not quantitative easing (QE); the goal is liquidity stability, not yield suppression. Nevertheless, it should still support the US Treasury’s shift towards more bill issuance and thereby help stabilise the broader curve. We expect US Treasury yields to remain broadly rangebound and sideways from here.
Beyond the trajectory of Fed interest rate policy, the bond market was also curious to learn more about the Fed’s balance sheet strategy at the last FOMC press release of the year. The central bank sees the necessity to resume balance sheet expansion only weeks after formally ending QT. This move is not a policy pivot but a direct (and logical) consequence of its ample-reserves operating framework. Recent volatility in repo markets signalled that reserves were approaching the lower bound of what is needed for stable rate transmission. Over the past months, liquidity has shifted from ‘abundant’ to merely ‘ample’. Estimating true reserve demand has become increasingly difficult in today’s regulatory and risk-management environment, but one indicator remains our initial metric to watch: bank reserves as a share of GDP have fallen rapidly, coming closer to 9%, a level historically seen as a sound operating threshold. In any case, the Fed announced very flexible reserve management purchases (RMPs), which will start in the area of USD40bn in December but will be adapted on a monthly basis depending on projected liquidity dynamics. Likely, we will see elevated net purchases over the next couple of months. This should remove some of the recent volatility in money markets. For bond markets, the key takeaway is that this is not QE. Purchases will be concentrated at the short end and are not aimed at suppressing long-term yields as was the case for QE. Still, these purchases should support the US Treasury’s shift towards more bill issuance and thereby help stabilise the broader curve. We expect US Treasury yields to remain rangebound and move broadly sideways from here.
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