The scale of the Fed's balance sheet reduction is expected to exceed $1 trillion this month, but the real test lies ahead.

The reduction in the scale of the Federal Reserve's balance sheet is expected to reach an important milestone of $1 trillion this month. However, market participants warn that further tapering could trigger financial market turbulence.

The Federal Reserve officially announced at the FOMC meeting in May last year that it would begin tapering its balance sheet from June 1, ending the super loose monetary policy since the early stages of the COVID-19 pandemic. As of August 9 this week, the Federal Reserve's investment portfolio has declined by $98 billion from its peak of $8.55 trillion in May last year. Based on the weekly reduction progress, it is expected to surpass $1 trillion by the end of this month.

Quantitative tightening (QT) is a dangerous and uncertain path. The departure of the largest buyer in the US Treasury market, the Federal Reserve, means that private investors need to absorb a larger amount of debt supply than before. This is not the first time the Federal Reserve has implemented QT. Its previous round of QT was forced to end in 2019 because the tapering led to a sharp rise in borrowing costs, a major stock market decline, and market panic.

The pace of the Federal Reserve's current tapering is almost twice as fast as the previous round, which also caused a storm in the market last year, with both US bonds and stocks plummeting. However, US stocks have started to rebound since the fourth quarter of last year and have entered a phase of bull market under the AI boom in March this year, which can be said to be "relatively safe" at present. US bonds also experienced a significant rebound from October last year.

Analysts pointed out that overall, the market has shown resilience so far, thanks to the abundant cash in the global financial system since the COVID-19 pandemic. However, further tapering is becoming more challenging in the future, as it will be accompanied by an accelerated pace of US bond supply.

The Federal Reserve plans to taper its balance sheet by an additional $1.5 trillion by mid-2025, at a time when the tightening monetary policy stance coincides with the US government's significant increase in debt issuance and weakened demand for US bonds from foreign investors. This may push up borrowing costs for the US government and corporations, and may cause losses for many investors who have bet heavily on US bonds earlier this year, expecting a bull market as the interest rate hike cycle ends.

Due to increased government spending and reduced tax revenue, the US Treasury has increased its bond issuance this year. Last week, the US Treasury announced its quarterly refunding plan, raising the size of long-term bond auctions for the first time in two and a half years, exceeding market expectations. The US government also plans to issue debt of various maturities on a larger scale. The US debt situation has already triggered a downgrade by Fitch Ratings.

Meanwhile, demand from the two major "overseas creditors" of US bonds is declining. The Bank of Japan made a slight adjustment to its yield curve control (YCC) policy in July, pushing Japanese bond yields to the highest level in nearly a decade. The rise in Japanese bond yields has led some investors to expect a large-scale capital outflow from Japan, withdrawing from US bonds. The TIC report for last month showed that China (excluding Hong Kong, Macau, and Taiwan) held $846.7 billion of US bonds in May, a decrease of $22.2 billion compared to April, approaching the lowest level since May 2010. Under the combined effect mentioned above, market participants expect that the yield on US Treasury bonds may rise significantly, especially for long-term bonds. This means that the yield curve will become steeper, even if the Federal Reserve has already ended or is about to end its rate hike cycle. As the issuance of US Treasury bonds will further increase in September and October, market volatility may be even greater.

Manmohan Singh, a senior economist at the International Monetary Fund (IMF), predicts that the next $1 trillion of quantitative tightening (QT) is equivalent to raising the federal funds rate by 15-25 basis points.

However, not all aspects are pessimistic. Unlike in 2019, there is currently no liquidity crisis. In September 2019, the US short-term funding market experienced a "money shortage," with overnight repo rates soaring to 10%. The Federal Reserve was forced to launch overnight repo operations for the first time in ten years, injecting a huge amount of funds into the money market. There is still a large amount of cash in the current financial system: although the usage has decreased, the Federal Reserve's reverse repo tool, designed specifically to absorb excess cash, still has a scale of $1.8 trillion. Although bank reserves have declined this year, they are still far above the level that concerns the Federal Reserve.

Nevertheless, the surge in US Treasury yields cannot be ignored. The 10-year Treasury yield, known as the "anchor of global asset pricing," rising sharply will mean higher costs for corporate borrowers and may weaken the upward trend of US stocks this year.

The "hardcore test" of long-term Treasury bond sales on Thursday is enough to sound the alarm. The results of this Treasury bond auction were dismal, with winning bid rates reaching the highest level since July 2011. Primary dealers received a large allocation, highlighting the market's difficulty in digesting large-scale long-term debt. This means that long-term Treasury bonds will face severe challenges in the future.