Fed's exit puts world's biggest bond market on shakier ground

Traders are worried about the world's largest and most important government bond market, as the Federal Reserve quickens the pace at which it removes one of its primary pandemic supports.

When the global economy crashed in March 2020 and markets went into free fall, the U.S. Treasury market - the $25 trillion bedrock of the global financial system - broke down. Sellers struggled to find buyers, and prices whipsawed higher and lower. The Fed stepped in, devoting trillions of dollars to steadying the market.

The Treasury market is the main source of funding for the U.S. government and underpins borrowing costs around the world, for a huge variety of assets.

That's why even small wobbles in this market can generate huge worries. At its worst, a Treasury trading breakdown could cause the value of the dollar, stocks and other bonds to tumble. Economies that borrow a lot in dollars and hold Treasuries in their reserves would teeter

In response to market turmoil in the early stages of the coronavirus pandemic in 2020, the Fed unleashed the full force of its firepower, buying mortgage bonds and government debt in huge quantities, in a move known as quantitative easing, or QE.

The Fed's balance sheet ballooned from a little more than $4 trillion in early 2020 to a peak of nearly $9 trillion two years later. Stability also brought investment back to the stock market.

Now, the Fed is reversing course through quantitative tightening, or QT, pulling back its support for financial markets while it raises interest rates to quell inflation. Some investors worry that the quickening pace of the Fed's pullback could become too much for markets to bear, undermining the safety and reliability of the Treasury market.

What market watchers are most worried about as the Fed's balance sheet shrinks is something called liquidity - trader jargon for the ease of buying and selling a financial asset.

Since June 2021, the Fed has been letting a small number of bonds mature without being replaced. Starting this month, the Fed will allow up to $60 billion of Treasuries and $35 billion of mortgage bonds to roll off its balance sheet as the debts come due, twice as much as the past three months.

As the Fed backs away, it's not clear who will fill the void.

(This article originally appeared in The New York Times.)