HSBC: The Federal Reserve's reduction of holdings will make U.S. Treasuries more reliant on price-sensitive buyers

HSBC strategist Dhiraj Narula and economist Ryan Wang stated in a report that if the Federal Reserve reduces its holdings of U.S. Treasury bonds, the U.S. Treasury market may become more reliant on buyers who are more sensitive to price.

If the Federal Reserve simply rolls over its existing U.S. Treasury holdings upon maturity, this will not have a direct impact on the valuation of U.S. Treasuries, as the scale of Treasury auctions aimed at private investors will not be affected.

However, the passive quantitative tightening—i.e., the policy stance taken by the Federal Reserve from 2022 to the end of 2025—and the "transmission mechanism" of reserve management purchases are somewhat complex.

During the period of passive quantitative tightening, when U.S. Treasuries held by the Federal Reserve mature and are not reinvested, it is ultimately up to the U.S. Treasury to decide how to refinance this portion of the debt.

Reserve management purchases will increase demand for U.S. Treasury bills, but whether this aligns with the rising demand for Treasury bills is determined by the U.S. Treasury.

They wrote, "A reduction in the Federal Reserve's holdings will still impact the U.S. Treasury market. If the growth of the System Open Market Account (SOMA) holdings does not keep pace with the growth of U.S. Treasury bonds, whether due to passive or relative quantitative tightening, or merely moderate growth in holdings, a larger proportion of government financing needs must ultimately be absorbed by price-sensitive investors."

The U.S. Treasury can decide which maturities of Treasury bonds this shift occurs in, but it cannot change the fundamental fact that the private sector needs to absorb more Treasury bonds.

Since the refinancing operations in May 2024, the issuance scale of coupon Treasury bonds has remained stable, with Treasury bills being used more to offset the increase in debt, and the favorable support obtained by Treasury bills has also supported the rise in their financing share.

They wrote, "However, if the issuance scale of coupon Treasury bonds remains unchanged, by fiscal year 2028, the net financing provided by coupon Treasury bonds will significantly decrease. Moreover, the longer the U.S. Treasury delays increasing the issuance of coupon Treasury bonds, the greater the risk that it will need to extend the debt maturity more quickly, which is also more likely to disrupt the market."

In this case, the term premium may soar, pushing the U.S. Treasury yield curve to steepen rapidly into a bear market