Head of Fixed Income Strategy
Summary: With the end of the Bank Term Funding Program (BTFP) and the Fed RRP facility falling below $500 billion, Quantitative Tightening (QT) tapering is coming next. Policymakers could decide on it as soon as at this month's FOMC meeting. Waller's comments at the 2024 US Monetary Policy Forum in New York may provide insight into what will happen next. There are three possibilities: QT tapering, a reverse Operation Twist, or a combination of the two. Regardless of the chosen option, the yield curve will continue to steepen, benefitting short-term US Treasuries. Conversely, the long end of the yield curve will remain vulnerable to pandemic-like US Treasury issuance, the pace of disinflation, and term premium considerations.
Last week, Federal Reserve Christopher Waller's speech discussed Quantitative Tightening (QT) in the past, the present, and the future. Yet, the following remarks were particularly important for bond markets:
1. The Fed’s agency MBS holdings should go to zero
2. US Treasury holdings should shift toward a larger share of shorter-dated Treasury securities.
To understand how such comments affect US Treasury and the yield curve, it is essential to know that today, T-Bills holdings are less than 5% of US Treasury Fed holdings and less than 3% of total Fed security holdings. Before the Global Financial Crisis (GFC), they comprised a third of the Federal Reserve portfolio.
Although Waller doesn't clearly state whether he would like to go back to a composition similar to the one seen before the GFC, it’s clear that he would like to limit QT to runoffs in MBS and coupon US Treasuries and avoid any runoff in T-Bills.
The issue is that QT is running at a rate of $60 billion US Treasuries per month and $15 billion agency MBS per month. The way QT works is that coupon bonds and notes are run off before T-Bills, but when the redemption of notes and bonds does not reach $60 billion, then T-Bills will be run off up to the $60 billion cap.
According to the Federal Reserve redemption schedule, US note and bond redemptions will meet or exceed QT’s cap in only five out of twelve months. If the current pace of QT remains unchanged, T-Bills will be runoff for roughly $170 billion in a year.
In 2019, MBS securities exceeding the QT cap were reinvested in US Treasuries in the secondary markets up to $20 billion; anything above that amount was reinvested in MBS. While one might think that the central bank today could opt for the same solution, it won't be able to do so this time. For the remainder of 2024, there will be only $14 billion of MBS redemptions, resulting in an average of a little over $1 billion per month, well below the $15 billion monthly QT cap.
Therefore, for the Federal Reserve not to reduce short-term Treasury holdings further, it would need to decrease the QT cap and redirect the debt exceeding the QT cap towards short-term US Treasuries
rather than rolling over the amount in proportion to the amount of SOMA securities scheduled to mature on those dates.
Another option would be to engage in a reverse "Operation Twist." The Federal Reserve implemented Operation Twist in the second quarter of 2012, which implies the simultaneous selling of short-term bonds to purchase long-term Treasuries.
Either way, QT tapering is indispensable and may come as soon as the next FOMC meeting on March 20th. Indeed, the Fed RRP facility has fallen below $500 billion this month for the first time since 2021, and the BTFP facility expires this month.
QT tapering or operation twist might be coming exactly as the US Treasury is increasing its T-Bill shares above the 20% guideline.
The above is likely to result in a steeper yield curve. However, the big question is whether QT tapering or operation twist is going to be bullish for long-term US Treasuries, especially the ultra-long part of the yield curve, where many investors have put their money at work in the past couple of years, positioning for an early and aggressive rate cutting cycle. Even during February, when markets were pushing against expectations of more than three rate cuts in 2024, TLT (iShares 20+ Year Treasury Bond ETF) saw inflows of $776 million.
Although the announcement of QT tapering per se is dovish, as it alludes to easier upcoming monetary policies, long-term US Treasury yields will be able to decline only once the market is confident that inflation is on a sustainable path to 2%. Moreover, considering that the US Treasury is maintaining coupon issuance to pandemic-like levels in the year's second quarter, long-term yields look more likely to rise rather than fall.
Yet, the front part of the yield curve up to 7 years offers an appealing entry point, as policymakers' reluctance to tighten the economy further and reduce liquidity in the system will likely favor this part of the yield curve. We continue to remain cautious.
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