The Federal Reserve's balance sheet reduction triggers "supply shortage" as the volume of failed deliveries for the 10-year US Treasury bond hits an eight-year high.

Due to the impact of the Federal Reserve's reduction of Treasury holdings since 2022, the US Treasury market has recently experienced noticeable friction. The latest data shows that the volume of failed deliveries for 10-year US Treasury bonds this month has soared to the highest level in eight years, highlighting the imbalance between supply and demand of key-term US bonds in the repurchase market. According to data released by the New York Fed, as of the week ending December 10th, the volume of trades involving the latest 10-year US Treasury bonds that failed to settle on time reached $30.5 billion, the highest since December 2017. As the failures in delivery became concentrated, the lending rate for this batch of 10-year Treasury bonds has seen an unusual drop. These bonds originated from a $42 billion auction held on November 12th, and in the repo market, some holders were willing to lend at negative rates, with the borrowers agreeing to sell back at a lower price the next day, making settlement failures more likely. Usually, before a new issuance of US bonds, it is not uncommon for related securities to experience "special rates" in the repo market due to the new supply not yet being in place. However, in the case of the 10-year US Treasury bonds set to settle on December 15th, the shortage of securities available on the market was significantly unusual. Industry insiders point out that one of the key reasons is the significant decrease in the number of this tranche of US Treasury bonds held and available for lending by the Federal Reserve. Jason Schuit, the President of South Street Securities, stated, "There are significantly fewer bonds available for lending. The Fed's purchase size for this 10-year bond is only half of the previous three cycles, directly causing a supply shortage and leading to failed settlements." Specifically, in the November auction of the 10-year US Treasury bonds, the Treasury sold $420 billion to private investors, with the Fed only adding $65 billion to replace maturing debt. In the previous three quarters with similar market issuances, the Fed's additional purchases were much higher, ranging from $115 billion (February) to $148 billion (May) to $143 billion (August). This change is directly related to the significant decrease in the size of Treasury holdings maturing in the Federal Reserve's System Open Market Account (SOMA). On November 15th, the maturing Treasuries in SOMA were less than $220 billion, while the corresponding sizes in February, May, and August ranged from $450 billion to $490 billion. The decrease in the size of maturing Treasuries in SOMA is a result of the Fed's balance sheet reduction policy implemented in mid-2022, only reinvesting when maturing Treasuries exceed the monthly limit. This limit has been raised from $300 billion in June to $600 billion in September. Within this framework, the Fed's additional purchases at auctions have decreased, weakening the supply of securities available for lending in the repo market. Market participants believe that this case illustrates that as the Fed continues to reduce its balance sheet, the "structural tension" of key-term US bonds in repo and settlement processes may become more frequent, posing a new challenge to the stability of short-term funding markets.