The Federal Reserve could be forced to slow the reversal of its asset purchase programme as deteriorating bond market liquidity could become worse than during the COVID-19 pandemic, MSCI has warned.

Liquidity in the bond market has worsened since the Fed announced its intention to slow its bond purchases last autumn and became worse still when it announced it would be reducing its bond portfolio from January this year.

“During the early days of the COVID-19 crisis, Fed chair Jerome Powell partly justified the Fed’s asset purchase program as necessary to restore market liquidity,” Greg Recine, vice president of MSCI Research, said.

“Today, it seems quite plausible that treasury market liquidity may soon be worse than what was experienced during COVID-19.”

The Fed announced a massive asset purchasing programme at the onset of the coronavirus crisis in March 2020 in a bid to restore the smooth functioning of the markets, including $8.56bn of fixed income ETFs, resulting in a massive improvement in liquidity conditions.

With markets returned to normality, the Fed announced plans to sell off its entire ETF holdings in June 2021.

From September this year, the Fed will look to accelerate its wider bond portfolio reduction, doubling the amount it sells to $60bn a month.

However, MSCI said Powell might be tempted to slow the run-off of its US Treasury portfolio to improve liquidity.

“The erosion in US Treasury market liquidity over the past 10 months could worsen as the Fed more aggressively reduces the size of its balance sheet.

“Investors in US Treasuries may face higher transaction costs, and institutions hedging with US Treasuries may incur greater trading losses resulting from hedge slippage.”

Such a move, he added, could further harm the Fed’s credibility with investors having wildly underestimated its inflation projections over the past year.

“Market participants will be closely following how the Fed balances market liquidity with its efforts to reduce the size of its portfolio – as will we.”

Last week, Ralph Axel, rates strategist at the Bank of America, said the issuer is the single largest systemic financial risk of the moment but urged caution on the Fed becoming a “buyer of last resort”.

“In our view, declining liquidity and resiliency of the US Treasury market arguably poses one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007,” he wrote.

“There is always a risk in the future that the Fed interprets its role in markets differently than what we saw in March 2020. It is risky in our view to rely on the Fed alone to solve the problem of US Treasury market liquidity, resilience and functioning.”

Axel said one way to boost overall liquidity would be to reduce the size of the US Treasury market.

“One way to shrink the size of the US Treasury market is to allow fungibility of treasury issues. This would allow for significant netting of positions and allow the dealer community to partly return to the shock-absorber role it played before the 2008 crisis.”

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