Written by Mike Dolan
LONDON (Reuters) – There is always the balance sheet.
Distressed bond markets are frantically repricing government borrowing costs to levels not seen in decades, raising fears that the turmoil could undermine broader markets and even economies.
The underlying reasons for the bond hype have been well publicized: investor anxiety about persistent US inflation, Federal Reserve interest rates, and ballooning debt as the new US presidential administration takes office.
But anxious investors seem to forget that central banks still have an incredibly powerful tool available: their balance sheets.
Central banks are charged with maintaining financial stability. If they see markets as unduly turbulent, they can build up their theoretically unlimited balance sheets at any time.
While the past two years have seen many major central banks take debt off their books and sell it outright in some cases, policymakers can always pull back if necessary.
We've seen this happen already. The Bank of England temporarily held back from reducing its balance sheet to successfully stabilize the government bond market in late 2022. The Fed did the same during the March 2023 regional bank turmoil.
Moreover, the Fed and other central banks already appear intent on halting the rewinding of their balance sheets – or “quantitative tightening” – as early as this year. Analysts expect nearly half a trillion dollars more to be spent in the United States before the program ends.
This runoff has not yet caused a shortage in US bank reserves or disrupted broader money market liquidity, according to the New York Fed's new monitoring tool.
For reference, the Fed's balance sheet of $6.9 trillion – down from a peak of more than $9 trillion in 2022 – now represents about 24% of nominal US GDP. This is 10 percentage points below the peak, but, unusually after all the pandemic interventions, it is actually lower than it was 10 years ago.
Balance balm?
The possible end of QT this year will partly pave the way for emergency interventions, if necessary.
This should also serve as a balm for bonds if things get out of hand.
Former New York Fed President Bill Dudley noted last year that once a sustainable balance sheet level is found, holdings should be concentrated in short-term securities and securities. Since any necessary interventions are likely to occur in the long term and can be easily financed through outstanding bills, this means that the overall size of the balance sheet will not change during the rescue operation.
However, it is clear that the size of central banks' balance sheets has become politically sensitive.
The consensus among monetary policymakers and governments alike in the post-pandemic phase is that the past 15 years of balance sheet expansion should become history, with every effort made to decouple monetary policy and financial stability issues.
This may be easier said than done if things go sideways. While markets may remain more volatile from here without central banks spurring action, the knowledge that this tool is available should remain a potentially strong buffer.
View before the global financial crisis
Although FOMC minutes show the Fed did not discuss much about the balance sheet last month other than a technical change in the reverse repo window, policymakers noted that the market was backing away from its assumptions about when the QT period would end.
Some Fed officials have also addressed the balance sheet issue in light of the ongoing bond sell-off this year.
Interestingly, Kansas City Fed President Jeff Schmid said last week that the size of the balance sheet is still putting downward pressure on market borrowing costs, raising the question of where bond yields could be if the QT is not lowered. .
Schmid estimated that 10-year bond yields, which are near 4.8% for the first time in 14 months, would be 50 to 100 basis points lower if the Fed's balance sheet were much smaller.
It's also useful to look at the so-called term premium in the Treasury market, which has risen back toward levels seen before the Fed's balance sheet first expanded around the 2008 banking collapse.
The New York Fed's estimate for the term premium over 10-year Treasury yields has returned to 65 basis points for the first time since 2014. But this is well below the average of 190 basis points seen in the 20 years prior to 2008.
While “counterfactuals” are difficult to prove, it is fair to say that the huge balance sheet continues to weigh heavily. It is also certain that the Fed and other central banks will not give up their right to use these powerful tools any time soon.
The opinions expressed here are those of the author, a Reuters columnist.
(Writing by Mike Dolan, Editing by Jamie Freed)
