Goldman Sees ‘Quantitative Tightening’ Fueling Treasury Volatility

(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.

The call by Goldman strategists including Praveen Korapaty follows remarks from Citigroup Inc. strategists, who said in a report published late last week 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, in Goldman's view, and also to tighten the gap between Treasury yields and swap rates at the shorter-end of the yield curve. 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.

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 Goldman strategists said.

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. And some observers have even suggested it might need to contemplate outright asset sales at some point.

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.

“While balance sheet unwind ought to be less impactful than the tapering of asset purchases, given the latter involves the loss of the ‘backstop,' the potential for more supply to the public in the absence of an active Fed presence does on the margin increase the likelihood of further reduction of liquidity,” Goldman strategists said.

Other observations from Goldman strategists:

Reserve balances, Treasury bill issuance and sources of Treasury demand imply about 5 basis points of upward pressure on the fed funds rate and about 9 basis points on the secured overnight financing rate relative to the interest on reserve balances rate by the end of 2023. They also expect the gap between T-bill rates and overnight index swap rates to widen around 4 to 5 basis points over the same period.
On the liability side, lower reserves and balances at the Fed's reverse repo facility should reflect the shrinking balance sheet, though the RRP is likely to see more initial decline. Strategists' base case is for about 35/65 reserve/RRP depletion ratio, “though there's considerable uncertainty on this front.”
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. They also expect Treasury will lean heavily on bill issuance to make up for this lost financing.