The Federal Reserve's program of shrinking its balance sheet, known as quantitative tightening, is expected to end next December. Analysts at Barclays Bank (LON:BARC) expect the completion of this program will not lead to major disruptions in financial markets, according to their latest analysis.
They note that this is a marked difference from the sudden halt of quantitative easing in 2019, which caused the cost of borrowing money to rise rapidly overnight. Barclays' analysis underscores the steps the Fed has taken to prevent a repeat of the mistakes of 2019 and to ensure a gradual and stable transition.
“The Federal Reserve continued to reduce its balance sheet for an excessive period in 2019,” Barclays noted. “The Fed did not accurately measure the level of additional cash reserves that banks wanted to hold as a safety measure, and paid too little attention to the specific range of overnight borrowing rates.”
On this occasion, the Fed is proceeding more cautiously. He expanded his monitoring of the conditions under which banks lend money to each other and began reducing quantitative reserves at a time when banks still hold more than $3.4 trillion in excess reserves. In addition, the implementation of a central counterparty for trades and the Standing Repo Facility (SRF) act as additional protection against a sudden increase in borrowing costs, similar to what happened in 2019.
Many indicators that previously warned of market difficulties in 2018-2019 are currently showing elevated levels. Hedge funds hold similar amounts of US government bonds, use secured loans to finance these positions, and securities traders have record levels of US government bonds on their books.
Now, Barclays believes that the Fed's comprehensive preparations and proactive actions will lead to a steady conclusion to the post-quantitative hedging phase.
“We identify two main reasons to expect a more regular conclusion to volume conversion this year,” the analysts wrote.
“First, the Fed appears to be paying more attention to a broader range of market conditions and not just focusing on overnight borrowing rates,” they stated.
The second reason for Barclays' optimism is the growth in short-term secured loan activity between financial institutions and the use of a central counterparty to settle trades since 2020. These developments have effectively allowed securities dealers to manage more transactions with the same amount of capital by offsetting conflicting transactions.
“The use of short-term secured loans between financial institutions – and the general reliance on a central counterparty to settle trades – has expanded the ability of securities dealers to manage more transactions with the same amount of capital by offsetting conflicting transactions. The volume of these transactions (which (involving both the assumption and lending of securities) exceeds US$1 trillion, and has more than doubled since 2019.”
In conclusion, Barclays expects the Fed to successfully complete December without any major disruptions and before any signs of distress appear in either overnight borrowing rates or the short-term collateralized loan market.
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