The U.S. Treasury Department’s debt-management unit likes sticking to one rule: Don’t surprise the market. The Federal Reserve is about to make that task trickier.
For years, the central bank has been the Treasury’s best customer, accumulating $2.46 trillion in U.S. debt through its cash injections aimed at stoking a recovery from the worst recession since the 1930s. That’s about to change as the Fed prepares to raise interest rates from near-zero, followed by a planned decision to let its balance sheet shrink at some point.
The risk is that once the Fed decides to stop reinvesting its maturing Treasuries into newly-issued debt, the Treasury would have little time to recalibrate its quarterly sale known as a refunding. The department could be forced to rely on tools that are unconventional or meant to be temporary, like issuing greater quantities of short-term bills. About $216 billion of the Fed’s holdings of Treasuries mature in 2016.
In a worst-case scenario, the government suddenly has to find buyers for debt the Fed would have otherwise bought, causing volatility in the market and higher yields than anticipated.
“This is definitely one of the biggest known-unknowns that they’re facing,” said Gennadiy Goldberg, U.S. strategist in New York at TD Securities LLC, one of the 22 primary dealers required to bid at U.S. debt auctions. “Treasury loves to be boring -- that’s their major goal. They hate uncertainty.”
The Treasury on Wednesday may provide a window into debt managers’ plans with its statement on the quarterly refunding, along with minutes from Tuesday’s discussions with bankers on its borrowing advisory committee.
The situation makes it challenging for the Treasury to plan the size and maturity of the notes it will sell. The department is testing tools such as buying back bonds, which would spread maturities more evenly over time and reduce the amount of debt it needs to refinance on a single day.
The department is contemplating the timing of the Fed’s reinvestment decision and has been highlighting the issue to market participants for several quarters, said a Treasury official who asked not to be identified. If the Fed redeems maturing securities, the Treasury would be underfunded by $775 billion from 2016 to 2018, the department told the advisory panel in August.
In February 2016, for example, $36.7 billion of Treasuries in the Fed’s possession mature, along with $39.3 billion in May, according to data compiled by Bloomberg. Total maturing debt is $194 billion in 2017, followed by $372 billion in 2018, the highest of any year for Fed-owned bonds.
To be sure, the debt the Fed could leave on the table is relatively small compared with the Treasury’s sale of $7 trillion in 2014, including $6.4 trillion to replace previously-issued securities. And demand from financial institutions including Bank of America Corp. is surging, partly because of rules requiring them to hold higher-quality assets.
Even so, the Treasury would prefer to communicate its issuance plans clearly, gradually and well in advance. While the Fed has said it will shrink its balance sheet in a “gradual and predictable manner,” the Treasury won’t get any more advance notice on a Fed policy decision than the public.
The central bank will end or taper reinvestments only after policy makers are comfortable that the process of raising interest rates is going well and the economic outlook is satisfactory, Chair Janet Yellen said in her September press briefing.
The 30-year bond and 10-year note-auction sizes have been unchanged since 2010. The value of the three-year note auction has generally declined by about $1 billion a quarter over the past five years, to $24 billion at the last refunding.
“The initial adjustments to some of the coupon sizes and some of the bill sizes might actually be a bit of a shock,” TD’s Goldberg said.
Some analysts, including Antulio Bomfim, a senior managing director at Macroeconomic Advisers LLC in Washington, have said the Fed will probably choose gradually to reduce reinvestment to soften the blow, similar to the tapering of bond purchases last year.
One temporary fix would be to sell short-term bills that normally see high demand in place of the long-term issues the Fed would have bought, said Michael Pond, global head of inflation-market strategy at Barclays Plc in New York.
“It could ramp up bill supply pretty quickly,” he said. “It would be a short-term solution” because the Treasury prefers longer-maturity debt, which locks in lower borrowing costs for taxpayers in case interest rates rise.
Other potential strategies include buying back debt due in one month and issuing similar debt in another month to spread out maturities, said Thomas Simons, a government-debt economist in New York at Jefferies Group LLC, also a primary dealer.
“They are looking for other solutions to try and mitigate the problem,” Simons said.