"Quantitative Tightening" or "Operation Twist" is coming up. What are the implications for bonds?

In 2019, MBS securities exceeding the QT cap were reinvested in US Treasuries in the secondary markets up to $20 billion; anything above that amount was reinvested in MBS. While one might think that the central bank today could opt for the same solution, it won't be able to do so this time. For the remainder of 2024, there will be only $14 billion of MBS redemptions, resulting in an average of a little over $1 billion per month, well below the $15 billion monthly QT cap.

Therefore, for the Federal Reserve not to reduce short-term Treasury holdings further, it would need to decrease the QT cap and redirect the debt exceeding the QT cap towards short-term US Treasuries

 rather than rolling over the amount in proportion to the amount of SOMA securities scheduled to mature on those dates.

Another option would be to engage in a reverse "Operation Twist." The Federal Reserve implemented Operation Twist in the second quarter of 2012, which implies the simultaneous selling of short-term bonds to purchase long-term Treasuries.

Either way, QT tapering is indispensable and may come as soon as the next FOMC meeting on March 20^th. Indeed, the Fed RRP facility has fallen below $500 billion this month for the first time since 2021, and the BTFP facility expires this month.

QT tapering or operation twist might be coming exactly as the US Treasury is increasing its T-Bill shares above the 20% guideline.

"QT tapering" and "Operation Twist Reverse": consequences on the yield curve.

The above is likely to result in a steeper yield curve. However, the big question is whether QT tapering or operation twist is going to be bullish for long-term US Treasuries, especially the ultra-long part of the yield curve, where many investors have put their money at work in the past couple of years, positioning for an early and aggressive rate cutting cycle. Even during February, when markets were pushing against expectations of more than three rate cuts in 2024, TLT (iShares 20+ Year Treasury Bond ETF) saw inflows of $776 million.

Although the announcement of QT tapering per se is dovish, as it alludes to easier upcoming monetary policies, long-term US Treasury yields will be able to decline only once the market is confident that inflation is on a sustainable path to 2%. Moreover, considering that the US Treasury is maintaining coupon issuance to pandemic-like levels in the year's second quarter, long-term yields look more likely to rise rather than fall.

Yet, the front part of the yield curve up to 7 years offers an appealing entry point, as policymakers' reluctance to tighten the economy further and reduce liquidity in the system will likely favor this part of the yield curve. We continue to remain cautious.

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