Fed asset purchases and liquidity

Inflation is coming in well above expectations, and central bank communications are beginning to point towards inflation being more persistent than initially thought. The shift in tone has prompted the market to bring forward the expected dates for central banks to raise rates. While there is plenty of uncertainty around the Omnicron variant, many market participants treat it as a source of ambiguity rather than a risk itself. The main risk for market participants remains the possibility of a policy error from central banks, which is ironic given that policy is a function of COVID-19 developments. As a result, volatility of interest rates has increased over the past quarter, and liquidity has deteriorated, particularly in the front end. With the Fed accelerating the pace of tapering, I figured I would summarize a good piece from GS that covers how asset purchases can suppress volatility in interest rate markets.

Ultimately, the Fed's primary way to reduce interest rate volatility is through being a price-insensitive buyer that offers market participants a way to offload risk from their balance sheets onto the Fed's balance sheet. Another mechanism, albeit less direct, is through forward guidance and sequencing, where the Fed has indicated a preference towards reducing asset purchases before raising rates. The sequencing reduces unknowns by giving market participants confidence that the Fed won't raise overnight interest rates until they decrease asset purchases. Finally, the purchase of Mortgage-Backed-Securities (MBS) can displace investors by reducing supply and forcing investors into volatility selling strategies to replicate the negative convexity of MBS. This volatility selling tends to reduce volatility in markets and is likely to dissipate if the Fed reduces purchases and increases the amount of MBS available to the street.

With the Fed reducing the pace of purchases, there is a heightened risk that volatility will increase and liquidity deteriorates. The factors above are channels through which the Fed can stabilize interest rate markets and, at the current juncture, all point to higher volatility in the short term. In addition, uncertainty around inflation is another unknown contributing to higher volatility and will likely lessen over the next year. With that said, market participants are grappling with the reaction function of central banks as it relates to higher inflation. What's muddying the picture is the labor market, which has not recovered to pre-pandemic levels, but recent commentary suggests that it may not need to recover to the Fed to meet its mandate. There are plenty of weird dynamics in the rates markets, but I think it's fair to say that volatility in the front-end will persist at least into the first half of next year.