The unwinding of central bank assets is already in question:Mike Dolan

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LONDON — It’s only just begun — but the prospect of central banks pulling out of bond markets and shrinking pandemic-bloated balance sheets looks more frightening and difficult by the day.

It was supposed to be the year of “The Great Unwind” – when central banks would let trillions of dollars of bonds accrued via massive COVID-related support programs run out of their accounts, helping to tighten market conditions to weed out resurgence of inflation and allowing markets to find their own feet.

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But the scale of this year’s energy shock and the resulting explosion in inflation – and the need to raise policy interest rates to achieve it – have left a bond market much more turbulent and much less stable to handle the process.

While the prospect of central banks tiptoeing away from bond buying may itself be a factor in exaggerating the blow to government bonds in Group of Seven economies at the moment, the idea of ​​a low-key, low-key central bank withdrawal without significant turbulence is being questioned.

Whether this is enough to stop so-called quantitative easing in its tracks is now a real topic of debate.

After a mid-year lull to see if central banks could rethink the severity of their bullish campaigns, this year’s bond attrition resumed with enthusiasm as monetary authorities on both sides of the Atlantic reported both larger upsides and a “higher-for-longer” scenario.

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Two-year US Treasury yields hit a 15-year high above 3.5% this week, after jumping nearly 70 basis points since the start of last month. Reflecting the dramatic shift in the Federal Reserve’s policy rate horizon, inflation-adjusted two-year Treasury yields saw their biggest one-month rise in at least 8 years.

With annual losses of nearly 14%, investment indices that track US government, agency and corporate bond aggregates are posting their worst year-over-year performance since 1980, which further undermines their traditional role in portfolios as diversifiers during years of steep equity declines.

The sell-off in other G7 bond markets has been even more violent over the past month. German 2-year bond yields saw their biggest monthly rise in August since 1981, while foreign investors fleeing UK gilts pushed 20-year yields there by the biggest monthly rise since 1978.

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Exaggerated by a soaring dollar, exchange-traded funds that track investment-grade non-U.S. government bonds see annual losses of about 24%, outpacing the 20% drop in the MSCI World Stock Market Index .

The sell-off may well be exactly what central banks want to tighten financial conditions, undermine economic activity and bring inflation rates back to target. But such a violent rift in debt markets risks making them highly illiquid, fragile, and prone to wild swings and destabilizing overshoots.

Buckle up

For 15 years, overshoots and instability in bond markets have seen central banks step in to calm the horses – but turbulence is now brewing as it heads for the door.

In addition to a likely third consecutive 75 basis point increase in its key rate this month, the US central bank is stepping up its QT program. This means it will allow up to $95 billion of bonds on its balance to mature per month without reinvesting the proceeds – including $60 billion in Treasury bills and $35 billion in debt backed by mortgages.

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If all goes well, this will take some $1.5 trillion off the outsized global total of $8.8 trillion by the end of 2023. Market participants believe that the drop in bond sales expected by the Treasury should offset this impact on demand, while any increase in government debt is likely to be concentrated first. in short-term bills.

But it’s the complex spaghetti of the Fed’s balance sheet and the direct effects on the Fed’s commercial bank reserves — and the safe levels of liquidity available to those banks — that seem to have people worried about the outcome.

A paper presented at the Fed conference in Jackson Hole last week by former International Monetary Fund chief economist and Reserve Bank of India Governor Raghuram Rajan and others points out that QT does not was not simply a dollar-for-dollar mirror reversal of the initial balance sheet expansion and may even make banks more prone to liquidity shocks.

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Citing the Fed’s experience in 2018 and 2019 of having to implement an emergency liquidity window via repos after its last episode of QT, the basic point of the paper is that commercial banks match the reserve assets built through QE with liabilities in the form of deposits. But when the former contracts, the latter does not necessarily and this creates financial stability risks for many weaker banks – and so this is not just a simple back to square one.

“If the past repeats itself, central bank balance sheet reduction is unlikely to be an entirely benign process and will require careful monitoring,” the economists concluded.

Others are more worried. “The Fed balance sheet reduction or QT is asymmetrical and non-linear in its effects. This will cause funding markets to fall,” said liquidity analysts at CrossBorder Capital. “That could force a liquidity pivot in 2023.”

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While the Fed likely thinks its repo operations can offset any problems, even this option may prematurely complicate its efforts to raise market interest rates to fight inflation – perhaps forcing a choice between raise the policy rate even higher than expected or suspend QT earlier.

Deutsche Bank calculations estimate that the Fed may have to actively slow any reduction in the $3.3 trillion of commercial bank reserves on its books when they fall to just $2.75 trillion by the middle of next year. .

As for other central banks?

The European Central Bank’s plans to unwind its balance sheet were complicated in July by demands to design a new ‘anti-fragmentation’ bond purchase facility to prevent excessive hikes in lending rates relative for indebted countries such as Italy if they are hit hard by rising policy rates.

The Bank of England is lower on the QT peak and expects active selling of its over £800bn of UK gilts and corporate bonds. But it is likely that huge additional government funding needs to alleviate this winter’s energy price crisis could push the BoE back into some form of targeted balance sheet expansion in parallel.

What goes up doesn’t always come down – at least not without stumbling.

(by Mike Dolan, Twitter: @reutersMikeD; editing by Josie Kao)

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Michael J. Birnbaum