Fed's $216 Billion Treasuries Rollover Recalls Crisis Era Buying

Fed Rate Cut Coming on Oil, Inflation: Komal Sri-Kumar
  • Portfolio has $1.1 trillion of U.S. debt maturing through 2019
  • Balance-sheet policy bigger focus than rates: Sage's MacQueen

If you were under the impression that the Federal Reserve was done buying Treasuries, think again.

While the central bank won’t be expanding its balance sheet, about $216 billion of Treasuries in its portfolio mature in 2016, up from negligible amounts the past few years. Last week, New York Fed President William C. Dudley reiterated policy makers’ plan to keep reinvesting the proceeds for the time being, giving bondholders and Wall Street dealers reason to cheer.

The Fed is the biggest holder of the government’s debt. Its $2.5 trillion hoard, amassed in a bid to support the economy after the financial crisis, is more of a focus for some investors than the trajectory of interest rates. From this month through 2019, about $1.1 trillion of Treasuries in the portfolio are set to mature.

For bond bulls, the Fed’s signals that it will roll over the obligations have been another reason to doubt the consensus forecast that yields will rise in 2016. If officials had chosen to stop funneling that money into new debt, the government would likely have to boost borrowing in the market by roughly an equivalent amount this year, potentially pushing up Treasury yields.

“The Fed tightening gave us little worry, but the unwind of the balance sheet gives us major worries,” said Mark MacQueen, co-founder of Sage Advisory Services Ltd., which manages $12 billion in Austin, Texas. “The Fed is keenly aware that the balance sheet has a much greater impact on the overall yield levels in the markets going forward than raising rates.”

QE’s Legacy

Officials anticipate keeping the holdings stable until the normalization of interest rates is “well under way,” though there’s no specific level for the Fed’s target at which reinvestment would end, Dudley said in prepared remarks of a speech Jan. 15. That ensures the legacy of the Fed’s quantitative-easing programs, which boosted its Treasuries holdings from less than $500 billion in 2009, will extend even further into the future. As officials roll maturing issues into new debt, that swells the amount coming due later in the decade.

With economic growth tepid and inflation below the Fed’s 2 percent target, officials are reluctant to pare the portfolio. Policy makers raised interest rates from near zero last month and project more increases this year.

Waiting until borrowing costs are higher “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,” Dudley said in his speech.

If the Fed had opted not to reinvest this year, the Treasury would have had to make up for the lost funding with additional debt sales that might have boosted 10-year yields by 0.08-0.12 percentage point, according to Priya Misra at TD Securities LLC, one of the 22 primary dealers that trade with the central bank. Misra, head of global rates strategy in New York, based the estimate on a 2010 study by the Fed on the link between its bond purchases and yield changes. 

Ten-year yields, a benchmark for borrowing costs including mortgages, were about 2.07 percent as of 8:02 a.m. in New York Tuesday, after touching the lowest since October last week on signs that global economic growth is cooling.

Rollover Ramp-up

“The Fed still wants to maintain as much accommodative policy as possible,” said Stuart Sparks, an interest-rate strategist in New York at Deutsche Bank AG, also a primary dealer. Maintaining the holdings is about avoiding “a disruptive increase in longer-term rates that could become potentially problematic to a housing market, which continues to heal after the crisis.”

The $216 billion of Treasuries the Fed has maturing in 2016 amounts to almost half the net new government-debt issuance that JPMorgan Chase & Co. forecasts for this year. And there’s no letup in sight: $194 billion comes due in 2017, about $373 billion in 2018 and $329 billion in 2019.

Because of Operation Twist, a maneuver in 2011-2012 through which the Fed sold shorter-maturity Treasuries and bought longer-dated securities, the Fed had little maturing through 2015. Last year’s tally was $3.5 billion, following $474 million in 2014, according to data on the New York Fed’s website.

Trading Grease

The reinvestments may aid the $1.6 trillion repurchase-agreement market, a crucial corner of the financial markets where dealers finance positions and find bonds to close trades.

As the central bank rolls over maturing Treasuries, it adds new debt -- known as on-the-run issues -- to its balance sheet. Since Operation Twist, the Fed has had less of those sought-after securities to lend out in a daily program it has to ease shortages in the market. As a result, these Treasuries have frequently commanded a premium in the repo market -- leading more trades to go uncompleted, or ‘fail,’ in bond parlance.

Unfinished Business

If the Fed’s stock of those Treasuries grows, the central bank should be better able to alleviate the shortages through its SOMA Securities Lending program, said Joseph Abate, a money-market strategist in New York at Barclays Plc, a primary dealer.

It will become “easier for people to access the securities they need to cover any shorts in the on-the-runs and, correspondingly, the level of fails should fall,” Abate said. “The more difficult it is to cover a short, the less liquidity there is in the market."

Dealers say bond trading has become more difficult as regulator-imposed risk limits make it costlier for banks to transact in all types of debt. While Treasuries remain one of the most liquid global markets, failing trades rose this month to about 2.5 percent of average daily volume, from about 1 percent before Twist, according to Barclays. The dollar amount of uncompleted Treasuries trades reached the highest since 2011 last month, Fed data show.

The continuation of the Fed’s reinvestment policy into 2016 “has important implications for both the Treasury and repurchase-agreement markets,” said Misra at TD. “Adding over $200 billion in new debt to the Fed’s holdings will provide dealers with a large universe to borrow from, and it has prevented the Treasury from ramping up supply.”

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