Alfonso Peccatiello | Apr 28, 2025 02:31AM ET
If long-end bond yields spiral out of control, the Fed could start injecting liquidity again: a step-by-step guide of how it works.
When a few weeks ago 30-year bond yields briefly flirted with the 5% level, the Fed's Collins released an interview stating that ''the Fed is absolutely ready to stabilize markets''.
To stabilize the bond market, they would ''inject liquidity'' through operations like the LSAP - Large Scale Asset Purchase or QE.
Central Banks create bank reserves when they perform such operations.
Bank reserves are often referred to as ''Liquidity''.
When Central Banks engage in liquidity creation, they do that in the hope that it activates the so-called Portfolio Rebalancing Effect.
To understand this, let’s start from what QE does to the balance sheet of a commercial bank - take a look at the chart below.
Following the GFC, regulators forced banks to own more HQLA (high-quality liquid assets) to meet depositor outflows.
Bank reserves and bonds qualify as ''HQLA'' as they are liquid enough to be converted into cash to meet potential outflows quickly.
But banks are not indifferent between owning bank reserves and bonds, and especially if the amount of reserves grows dramatically as a result of QE.
Bank reserves are a zero-duration and low-yielding instrument that can be suboptimal to own in large sizes, especially if compared with bonds, which offer higher returns and duration hedging properties.
And this is when the Portfolio Rebalancing Effect kicks in.
This will kick in a virtuous cycle of low volatility and a hunt for riskier assets: the Portfolio Rebalancing Effect in action.
Does the Portfolio Rebalancing Effect make sense to you?
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