Wednesday, April 8, 2015

The Federal Reserve's Other Big Decision

While everyone focusses on the Federal Reserve's upcoming interest rate timing decision, there is another significant decision that the great minds at the Fed will have to make in 2016.  This decision could have a marked impact on interest rates that the Federal Reserve will have little control over.

Let's start by looking at the Federal Reserve's balance sheet which are held in the Federal Reserve System Open Market Account (SOMA):

Right now, the Fed has the largest inventory of U.S. Treasuries held by a single holder.  As of April 1, 2015, the $4.228 trillion in securities in the Fed's balance sheet is made up of $2.459 trillion in U.S. Treasuries and $1.732 trillion in mortgage-backed securities.  The $2.459 trillion in U.S. Treasuries is composed of $2.347 trillion in Treasury Notes and Bonds and $98.47 billion in inflation indexed Treasury Notes and Bonds (TIPS).  Note that more than half of these Treasury securities (61.4 percent) are held by the Federal Reserve Bank of New York as shown on this table:

It is also interesting to note that the Federal Reserve now owns 22.5 percent of the $10.947 trillion in outstanding U.S. Treasury Notes, Bonds and TIPS according to SIFMA data.

Here is a table showing the maturity distribution of the Fed's Treasury inventory:

Here's the conundrum.  Over the full year 2015, only $4.8 billion worth of U.S. Treasuries held by the Federal Reserve will reach maturity.  Things change dramatically in 2016 when approximately $216 billion of the Federal Reserve's holdings of U.S. Treasuries mature.  At this point, the Fed must make a decision; do they allow the Treasuries to mature and reduce the size of its balance sheet or do they reinvest the proceeds, keeping the size of its balance sheet at a constant level?  Obviously, the federal government will have to reissue the Treasuries since the federal debt is not getting smaller.  This means that if the Fed decides not to reinvest the $216 billion, there will be more Treasuries available for investors and, as supply rises, prices will decline and yields will rise.

The Federal Open Market Committee has given us a bit of a clue about what they plan to do about their bloated balance sheet in their press release dated September 17, 2014:

"The Committee intends to reduce the Federal Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA.

The Committee expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate; the timing will depend on how economic and financial conditions and the economic outlook evolve.

The Committee currently does not anticipate selling agency mortgage-backed securities as part of the normalization process, although limited sales might be warranted in the longer run to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public in advance.

The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy." (my bold)

Right now, the economy is extremely fragile.  This means that the timing of the unwinding of the Federal Reserve's massive balance sheet could be even more important than the timing of the first and following interest rate increases.  One misstep on the balance sheet unwinding, and the economy could find itself under significant negative pressure.

1 comment:

  1. In a recent article written by bond king Bill Gross titled "Going To the Dogs" Gross describes some of the current economic conditions we face. His thoughts strongly dovetail with my concerns as to how these low rates distort and cause massive misallocation of resources throughout the economy.

    The growth in sub-prime auto loans is a glaring confirmation of this and the main reason for surging sales in the auto sector. This effort to offset the dwindling buying power of the public sector by encouraging them to take on more debt by easing terms and artificially low interest rates will not end well. Below is an article that looks deeper into the flaws in this policy.