By Karen Brettell

(Reuters] – The Federal Reserve will begin letting its bonds mature on its $9 trillion balance sheets. It is important to monitor whether Treasury volatility improves in a market suffering from low liquidity.

QT, the Fed’s quantitative tightening, could increase yields, although analysts believe this will be dependent on other factors, such as the direction of economic activity.

As part of its efforts to stabilize policy and lower inflation, the Fed will allow bonds to mature from its balance sheets without replacing them. This is in response to unprecedented bond purchases that were made from March 2020 through March 2022. It was intended to reduce the economic effects of closing down businesses during the pandemic.

But as the world’s largest holder of U.S. government debt reduces its presence in the market, some worry the absence of its dampening effect as a consistent, price-insensitive buyer could worsen market conditions.

“The impact of QT will be more evident in places like money markets and in market functioning as opposed to yield levels and curves,” said Jonathan Cohn, head of rates trading strategy at Credit Suisse in New York, adding that he will be watching “the way in which it proceeds through deposits, through the withdrawal of liquidity and through the added burden that it places on dealers.”

At a time the Treasury market was experiencing periods of slow trading, the Fed has begun to pull back. U.S. debt has increased while banks are subject to greater regulatory restrictions, which has hindered their ability for intermediate trading.

“On the margin we could see a little bit weaker liquidity in the Treasury market because there’s no opportunity to sell bonds from dealer balance sheets on to the Fed,” said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia. “That might increase volatility, but liquidity is also already pretty thin within the rates space and that’s not necessarily directional.”

This year, banks have cut their bond buying. Hedge funds may have reduced their presence due to losses suffered during periods of volatility. As hedging costs increase and foreign bond yields rise, investors from abroad have shown less interest to U.S. bonds.

To the degree that the Fed’s retreat does impact yields, it will most likely be higher. Many analysts believed that the Fed maintained benchmark yields artificially low in April, contributing to an abrupt inversion of Treasury yield curve.

“The risk is the market is unable to absorb the additional supply and you do have a big adjustment in valuations,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities in New York. “We will still see more long-end supply than we did pre-COVID for quite some time, so all else being equal that should pressure rates a bit higher and the curve a bit steeper.”

The direction of yields, however, will still be influenced by other factors, including expectations for the Fed’s interest rate hikes and the economic outlook, which could override any impact from QT.

“From a top-down macro perspective we think other determinants will be just as or likely even more important for thinking about the direction of yields,” said Credit Suisse’s Cohn.

Last time that Fed reduced its balance sheets, it was disastrous. In Sept. 2019, rates to borrow on the vital overnight repurchase arrangement market surged. Analysts attribute this to the Fed’s decision to reduce its balance sheets from Oct. 2017 and to too low bank reserves.

It is not likely to happen this time, as the Fed established a standing repo facility which will serve as a temporary backstop for the critical funding market.

There is also significant excess liquidity in the form of bank reserves and cash lent into the Fed’s reverse repurchase facility, which may take time to work through. The bank reserves are now at $3.62 trillion. This is a sharp increase from the $1.70 trillion recorded in December 2019. Demand for the Fed’s overnight reverse repo facility, where investors borrow Treasuries from the Fed overnight, set a record at more than $2 trillion last week.

In addition, the Fed has been slowing down to reach its $95 billion monthly bond limit that will enable it to release its balance sheets each month. The September full implementation of this plan will see $60 billion in Treasuries, $35 billion in mortgage-backed and $35 billion in Treasuries. These caps will remain in effect until September at $30 billion and $157.5 billion.

“It’s going to be very gradual… It’s just too soon to know what if anything the impact is going to be from QT,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale (OTC:) in New York, noting that any issues may not begin to surface until the fourth quarter.