Federal Reserve Chairman Ben S. Bernanke may hit an obstacle as he considers whether more bond purchases are needed to spur growth: owning too much.
Excessive Fed buying of Treasury securities may reduce liquidity by leaving less for private investors to buy, said Nathan Sheets, global head of international economics at Citigroup Inc. Bernanke instead may favor buying mortgage-backed securities or using new tools for easing, he said.
Purchasing too many Treasuries may “have a serious long-term effect on the market,” Sheets, who until last August was the Fed’s top international economist, said in a phone interview. “The Fed implicitly has a mandate for financial stability, and as part of that they’re concerned about ensuring the functioning and integrity of financial markets.”
Bernanke testified to Congress last week that the Fed is evaluating additional steps to create jobs and reverse an economic slowdown, including buying mortgage bonds or changing language for its policy outlook. Unemployment hasn’t dropped below 8 percent even though the central bank has held its main interest rate near zero since December 2008 and purchased $2.3 trillion in bonds. Policy makers plan to meet July 31-Aug. 1.
Some Fed officials believe continued purchases of longer-term Treasury securities may “lead to deterioration in the functioning of the Treasury securities market that could undermine the intended effects of the policy,” according to minutes of their June 19-20 meeting. Policy makers said it would be “helpful” to determine the magnitude of Fed holdings in Treasuries that would harm the market.
“They are obviously concerned about the costs of disrupting the Treasury market and probably” the market for mortgage-backed securities, said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York. “They are thinking about liquidity and smooth market functioning” and how to ensure “the market doesn’t start to get clogged up.”
Still, the central bank will probably begin a third round of large-scale asset purchases in September to fulfill its congressional mandate to achieve maximum employment, said Hanson, a former economist in the Fed’s division of monetary affairs. “Ultimately their dual mandate probably trumps most concerns about market functioning.” Price stability is the second part of the mandate.
The Federal Open Market Committee last month voted to prolong Operation Twist, which is intended to push down long-term borrowing costs by extending the maturities of assets on the Fed’s balance sheet. Also, as many as four policy makers were “quite receptive at this time” to more asset purchases, Atlanta Fed President Dennis Lockhart said July 13, citing minutes of the June meeting.
The Fed’s programs have helped reduce borrowing costs to record lows. The yield on the 10-year U.S. Treasury note declined to 1.44 percent at 3:25 p.m. in New York after reaching an all-time low of 1.4 percent. The yield on the 30-year bond fell to 2.51 percent after reaching a record 2.48 percent.
Average daily trading in U.S. government securities was $438.3 billion as of July 11, according to primary dealer data from the Fed compiled by Bloomberg News. That compares with an average of $571.3 billion in 2011.
The decline in volume comes as international investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. That shortage is helping drive up the value of the dollar. Intercontinental Exchange Inc.’s Dollar Index has risen 13 percent in the past year.
Lower Treasury yields have helped hold down the cost of mortgages and other debt. The average 30-year fixed-rate mortgage fell to a record 3.53 percent on July 19, according to an index from Freddie Mac.
The Fed owns $1.65 trillion of Treasury securities, $91 billion of Federal agency debt and $863 billion of mortgage-backed securities. While those amounts are small compared with the $10.5 trillion Treasury market, the Fed has concentrated its purchases in longer-duration assets.
For example, the U.S. government has $405 billion of debt maturing in the year 2021, according to data compiled by Bloomberg News. The Fed owns $128.6 billion of that debt, or more than 30 percent. That share will grow as the central bank purchases $267 billion of longer-term securities through the extension of Operation Twist.
Pace of Purchases
“If you keep buying bonds at the pace they may have to, you’re certainly going to be complicating market functionality,” said Dan Greenhaus, chief global strategist at BTIG LLC in New York.
Prior to the financial crisis and the collapse of Lehman Brothers Holdings Inc. and Bear Stearns Cos. in 2008, the central bank’s balance sheet was less than $900 billion and consisted primarily of short-term Treasury securities.
In December of 2007, 77 percent of the Fed’s portfolio of Treasury securities had less than five years to maturity.
The Fed combatted the financial crisis through two rounds of quantitative easing. In the first round starting in 2008, the Fed bought $1.25 trillion of mortgage-backed securities, $175 billion of federal agency debt and $300 billion of Treasuries. In the second round, announced in November 2010, the Fed bought $600 billion of Treasuries.
Policy makers will be wary of impairing a debt market used to fund the federal deficit and which investors deem a benchmark for fixed-income markets worldwide, said Stephen Stanley, chief economist for Pierpont Securities LLC in Stamford, Connecticut.
“If they’re doing something that threatens to ruin the Treasury market, you can be certain that folks at Treasury are going to squawk pretty loudly,” Stanley said. “If the market for the government to finance itself doesn’t work we’d have really big problems.”
Bernanke said in response to questions from lawmakers that Fed purchases of Treasuries would eventually backfire.
“Beyond a certain point, if the Federal Reserve owned too much it would greatly hurt market functioning,” he said. “I wouldn’t say that we’re at that point yet. But ultimately there would be some limit to how much you could do.”
Bernanke said he doesn’t “have a number” for the level of purchases that would prove harmful, adding “we still have some capacity at this point.”
“You still want a functioning market, you still want there to be bids,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, one of 21 primary dealers that trade directly with the Federal Reserve. “You can’t do so much that it harms liquidity further.”
Central bank buying in recent years has already disrupted markets. By purchasing mortgage-backed securities the Fed reduced available supply. As a result, investors were unable to complete an unprecedented amount of trades.
Uncompleted trades in the $5 trillion market for agency mortgage securities rose to a record of almost $2.4 trillion during a week in November of 2010, according to Fed data. That compared with a weekly average of about $300 billion over the past 10 years.
The data encompass incomplete trades continuing over many days and strings of failures triggered by a single party that doesn’t settle a contract.
The constraints of supply mean that new Fed buying of government-backed mortgage bonds would be limited to no more than $500 billion to $600 billion a year, according to research by Barclays Plc.
“The agency MBS market might have more trouble accommodating the Federal Reserve this time,” Barclays analysts, including Nicholas Strand, Siddarth Ramkumar and Sandipan Deb wrote in a June 15 report.
Several Fed officials at their June meeting said the central bank should look into “new tools” to improve financial conditions and boost the economy.
The search by policy makers for new ways of stimulus stems partly from their “concern about preserving the markets and not doing any irreversible damage to them,” Citigroup’s Sheets said.