The Federal Reserve's Treasury Dilemma

Updated March 2016

While everyone focuses on whether the Federal Reserve will raise interest rates again in 2016, one aspect of the Fed's actions are being pretty much ignored as you will see in this posting.

Let's look at what has happened to the Federal Reserve's balance sheet since it took unprecedented actions to rescue the U.S. economy back in September 2008:

The Fed's balance sheet grew from around $900 billion in August 2008 to its current level of $4.535 trillion on January 14, 2016, an increase of $3.635 trillion or roughly 400 percent.

Let's look at the latest statistical release from the Federal Reserve dated March 10, 2016 which shows us the assets held by the Fed:

As of March 2016, the Federal Reserve held $2.461 trillion worth of U.S. Treasuries which was composed of $2.346 trillion worth of Treasury notes and bonds and $98.5 billion worth of inflation-indexed Treasury notes and bonds.  Thanks to its long-term monetary policy experiment, the Federal Reserve is now the largest holder of government debt, owning 21.7 percent of the total $11.348 trillion in outstanding Treasury notes, bonds and TIPS. 

Now, let's look at a table that shows us the maturity distribution of the Federal Reserve's massive inventory of U.S. Treasuries:

In case you are interested or curious, here is a complete listing of all of the Treasury notes and bonds held by the Federal Reserve.  One problem that has occurred because of the Fed's massive holdings is that there are less Treasuries for sale on the open market, meaning that certain Treasuries either command a premium (i.e. higher price and lower yield because supply is lower than demand) or trades simple fail because there is a shortage of certain Treasuries as shown on this graphic which shows the growing daily Treasury settlement delivery fails in billions of dollars for the last year:

Over the next year, the Federal Reserve has a total of $216.11 billion worth of Treasuries that are maturing, a far larger volume than in any other year since QE1 began.  If we look further down the line, over the next five years, the Fed will hold $1.334 trillion worth of maturing Treasuries.  Here is a table showing a more detailed view of the Fed's maturing inventory of Treasuries:

The Federal Reserve has already announced that it will not be selling its massive inventory of Treasuries to normalize its monetary policy, rather, it will raise interest rates by increasing the interest rate that it pays banks on the reserves deposited at the Fed, which it did on December 17, 2015 (up to 0.50 percent from 0.25 percent) and continuing its experiment with reverse repurchase agreements. In other words, as shown here, the Fed will roll over its maturing Treasury securities into new Treasury securities:

"As directed by the FOMC, the Desk is rolling over maturing Treasury securities at auction. However, for operational efficiency, when the proceeds received by the SOMA from Treasury securities that mature on a given day total less than $2 million, the Desk will allow those securities to mature without reinvestment.

For example, if on a given date the SOMA holds two Treasury coupon securities maturing with balances of $0.5 million and $1.1 million, the full $1.6 million would be allowed to mature without reinvestment. However, if the balances of the maturing securities on that date were instead $0.5 million and $1.6 million, the full $2.1 million would be reinvested into newly issued Treasury coupon securities at auction."

At its December 16, 2015 meeting, the FOMC reaffirmed its commitment to rolling over its maturing Treasuries.  Additionally, a recent speech by William C. Dudley, President of the Federal Reserve Bank of New York and Vice Chairman of the Federal Open Market Committee stated that:

"Let me close with some observations about my current thinking concerning our reinvestment of maturing Treasury securities and paydowns in our agency MBS holdings. As we noted in the December FOMC statement, we anticipate that we will continue reinvestment “until normalization of the federal funds rate is well underway.” I think this policy makes sense not only because the decision to end reinvestment will represent a further tightening of monetary policy, but also because it is difficult to assess ahead of time the impact of such a decision on financial market conditions given the lack of historical experience.

I also believe that continuing reinvestment until the federal funds rate reaches a higher level makes sense. We want to ensure that we have the ability to respond to adverse shocks by easing monetary policy by lowering the policy rate. Having more “dry powder” in the form of higher short-term interest rates seems more desirable than less dry powder and a smaller balance sheet." (my bold)

By signalling that it will continue to reinvest its massive portfolio of Treasuries, the speech by William Dudley shows that the Fed is concerned about two things:

1.) What will happen to the Treasury market when the Fed ends its unprecedented monetary policy since there is no historical precedent?  As well, since Treasury prices behave inversely to yield, as yields rise, prices will drop, leaving the Fed with a capital loss on the value of their portfolio that could prove to be very significant.

2.) Ending the reinvestment program will represent a further tightening of monetary policy because it means that the Treasury will have to make up the lost funding by selling additional debt which will push interest rates higher whether the Fed likes it or not.  

As the Fed rolls maturing issues into new debt, the amount that comes due later in this decade and into the 2020's rises, kicking any potential problems further down the road and through the next recession.  A 2010 study by Stefania D'Amico and Thomas King at the Federal Reserve Board's Division of Monetary Affairs suggests that the Fed's large-scale asset purchases of $300 billion during 2009 resulted in a persistent downward shift of the yield curve by as much as 50 basis points (one-half percent) with the largest impact being on the 10 to 15 year sector.  It is this sector that largely dictates the interest rates on mortgages and other loans.  This research suggests that we could see substantial increases in interest rates once the Fed starts to divest.   

As I have explained in many postings, no one really knows the long-term ramifications of the Federal Reserve's 7 year program of monetary policy experimentation.  As this posting shows us, the Fed's massive Treasury inventory is likely to prove problematic, particularly if they continue to rollover the hundreds of billions of dollars worth of government debt into the distant future.  The acquisition of trillions of dollars worth of Treasuries could have a detrimental impact on the Fed's ability to move interest rates in the future, particularly since reducing the inventory will put significant upward pressure on yields at a time when the global economy is looking particularly fragile.