"Backing up market liquidity? Bank of America: The Fed is expected to absorb $2 trillion in US debt to resolve the fiscal 'water extraction crisis'"

According to the Bank of America, the Federal Reserve's portfolio of US Treasury bonds may undergo changes, which could lead to the central bank purchasing nearly $2 trillion in short-term bonds over the next two years, enough to absorb all of the Treasury's bond issuance during that period. If the Fed were to take such action, it would alleviate concerns that large-scale issuance of US Treasury bonds would deplete market liquidity. Bank of America strategists Mark Cabana and Katie Craig expect the Fed to adjust its asset portfolio to better match assets with liabilities. This is aimed at mitigating interest rate risk and negative asset conditions, while also shortening the duration of liabilities. This would also provide much-needed revenue for the Treasury as they have been issuing billions of dollars in short-term bonds to cover expanding deficits, and supplement cash balances following the debt ceiling increase last month. Cabana, head of the Bank of America's interest rate strategy division, said in a separate interview, "If you do some operations to the Fed's balance sheet and assume that mortgage-backed securities are reinvested into bills, then the balance sheet turns into bills, they are recovering Treasury securities that mature and converting them to bills, approximately equivalent to $1 trillion. It's somewhat incredible that the Treasury issues $1 trillion in bills and the Fed buys those bills. This is creating a new source of demand at the front end of the market." The Bank of America strategists wrote in a report on Friday that money management institutions could convert nearly 50% of their assets into Treasury securities to match their short-term liabilitiesmostly reserves and reverse repurchase agreementswhile also absorbing changes in Treasury cash balances. They estimate that the supply of Treasury bills will reach $825 billion in the fiscal year 2026 and $10.67 trillion in the fiscal year 2027, assuming the Treasury maintains auction sizes unchanged before October 2026. Meanwhile, as the Treasury intensifies bond issuance to supplement cash reserves, market participants are increasingly concerned about signs of potential liquidity constraints in the financing market. Since the US Congress raised the debt ceiling last month, the Treasury has issued approximately $328 billion in short-term government bonds to supplement its cash reserves. This has led to funds flowing out of the financial system, making the financial system vulnerable to unexpected events. If the Fed were to take such action, it would ensure strong demand for short-term government bonds, thereby alleviating concerns that large-scale issuance of US Treasury bonds would deplete market liquidity. The strategists mentioned that while the Fed is still gradually reducing its balance sheet (a process known as quantitative tightening), recent comments from policymakers suggest that discussions regarding investment portfolios may appear in the minutes of the Federal Open Market Committee meeting scheduled for August 20th, which will be released in September. Fed Governor Waller has suggested for the central bank to adopt such practice to ensure the "optimal mix." A recent report by a senior Fed advisor also advocates for this policy. After several rate cuts by the end of 2024, the Fed has not adjusted its benchmark interest rate this year. Consequently, the Fed's total net income from the public market accounts remains negative as interest payments on reserves and other liabilities paid to banks exceed the income from the bonds they hold, putting pressure on the Fed in terms of other expenses. A research report from the Dallas Fed analyzed three asset allocation methods and evaluated the pros and cons of each. The report concluded that term matching helps reduce yield volatility, while diversified investment portfolios are more feasible in reducing concentration risk. According to Bank of America, the Fed has several options to quickly increase its holdings of bills. The first option is to reinvest the proceeds from maturing and early repayment of mortgage-backed securities, which could reach $10-20 billion per month. Another option is to increase reserve balances to offset the growth of non-reserve liabilities and keep them stable, which would require approximately $10-20 billion per month. The final option is to reinvest all maturing Treasury bond interest into short-term Treasury bills, with monthly purchases estimated to be between $20-60 billion. The Fed is likely to adjust its reinvestment strategy immediately after ending its balance sheet reduction plan, with the two Bank of America analysts expecting this operation to be completed as early as December 2025.