Ebbing Deficit Likely to Keep Rates Low When Fed TapersJoshua Zumbrun
Federal Reserve policy makers say they want to avoid a sudden increase in interest rates when the time comes to start unwinding record monetary easing. A shrinking federal budget deficit is likely to help them meet that goal.
The Treasury Department will be selling less debt as surging tax revenue, automatic spending cuts and payments from mortgage-finance companies Fannie Mae and Freddie Mac narrow the budget gap. The shrinking supply of Treasuries will put downward pressure on yields as central bankers consider the as-yet-undetermined timing of a reduction in the central bank’s $45 billion of monthly purchases of U.S. debt, a step that would by itself push yields higher.
“If the Treasury reduces supply as the Fed reduces purchases of Treasuries, then your net impact on yields should be left unchanged,” said Drew Matus, deputy chief U.S. economist for UBS Securities LLC in Stamford, Connecticut, and a former analyst on the New York Fed’s open market desk.
Chairman Ben S. Bernanke is leading Fed efforts to smooth the transition from unprecedented monetary easing intended to lower unemployment and then to withdraw its stimulus in a way that doesn’t damage the economy. One outcome Fed officials seek to avoid is a jump in bond yields like the one that occurred in 1994, when they began tightening policy.
Officials last week expressed a range of views on when to begin winding down their purchases. Philadelphia Fed President Charles Plosser called for shrinking purchases at the Fed’s next meeting; San Francisco’s John Williams favored a reduction “perhaps as early as this summer,” and Boston’s Eric Rosengren said low inflation and high unemployment suggest there may be a need for more stimulus, not less.
Bernanke will testify on the economic outlook before the Joint Economic Committee of Congress on May 22. He may provide clues as to how he views the narrowing deficit and whether he sees the Fed making enough progress toward its goal of a substantial improvement in the labor market to warrant reducing its $85 billion monthly pace of bond purchases, which include $40 billion in mortgage-backed securities.
The yield on the 10-year Treasury note traded at almost a two-month high today on speculation the Fed may start to slow the pace of monetary stimulus as the economy shows signs of improving. The yield was at 1.96 percent at 4:32 p.m. in New York.
U.S. stocks fell, after the Standard & Poor’s 500 Index climbed for four straight weeks, as investors weighed the outlook for Fed stimulus. The S&P 500 retreated less than 0.1 percent to 1,666.29 at the close in New York.
Elsewhere, China’s new-home prices increased last month in 68 of 70 cities tracked by the government, a report from the National Bureau of Statistics showed on May 18, indicating Premier Li Keqiang will need to maintain efforts to cool the property market even as economic growth slows.
In the U.K., home sellers raised asking prices for a fifth consecutive month, property-website operator Rightmove said in a report today, pushing values to a record and giving the market its best start to a year since 2004.
The U.S. Congressional Budget Office estimated last week that the deficit will shrink to $642 billion in the fiscal year ending in September, the smallest shortfall in five years. The agency reduced its estimate by more than $200 billion compared with February projections.
The Fed began buying $40 billion a month of mortgage-backed securities in September and announced another $45 billion in monthly purchases of Treasury securities in December. At that pace, the Fed would purchase $540 billion of Treasuries a year.
That would leave little new supply of Treasuries for others who might be interested in buying government debt, said John Herrmann, director of U.S. interest-rate strategy at Mitsubishi UFJ Securities in New York.
If the Fed scales back purchases, that “could allow the natural buyers of Treasury, like life insurance companies, or banks, to still pursue their relatively normal behavior.”
Insurers or pension funds need a steadily growing supply of Treasuries to manage their future obligations. Tapering purchases as the supply shrinks may help ensure a smooth market reaction, said Herrmann.
“All else being equal, it would tend to keep yields from ratcheting up,” he said.
The Fed owned $1.86 trillion of Treasury securities as of May 15, according to its weekly balance sheet report, or about a sixth of the $11.4 trillion in total outstanding marketable U.S. debt. Much of that supply may be held by investors or institutions that don’t intend to sell their holdings.
The yield on the 10-year note, which hasn’t climbed above 2.5 percent since August 2011, is projected to reach 2.18 percent by the end of the year, according to the weighted average in a Bloomberg survey of 74 forecasters. The yield fell to a record 1.39 percent in July of last year.
New York Fed President William C. Dudley has outlined what the Fed looks for in determining if its unprecedented stimulus campaign is causing disruption.
“We carefully monitor financial markets for signs that market functioning has been impaired, looking at metrics such as trading volumes, bid-offer spreads, failures to deliver securities and our own ability to execute transactions,” Dudley said in a March 25 speech in New York.
“On some of these metrics, market functioning has actually improved in recent months,” he said. “So far, so good.”
The Fed is monitoring this risk in both Treasuries and mortgage-backed securities. The central bank’s concerns are more than hypothetical: the mortgage market was disrupted after the first round of so-called quantitative easing, or QE, concluded in 2010 with $1.43 trillion of housing debt.
By acquiring about 25 percent of home-loan bonds with government-backed guarantees in its bid to bolster housing prices and the economy, the Fed made some securities so hard to find that Wall Street was unable to complete an unprecedented amount of trades. Weekly failures to deliver or receive mortgage debt climbed above more than $1 trillion in 2010, compared with a weekly average of $150 billion in the five years through 2009, according to Fed data.
The open-ended nature of the current QE program could create a new shortage in the Treasury or mortgage market as the Fed’s balance sheet grows, said Stephen Stanley, the chief economist at Pierpont Securities LLC in Stamford, Connecticut.
“The longer QE goes on, the more likely it is to be more of a problem from a liquidity standpoint,” said Stanley, a former Richmond Fed economist.
Stanley said the Fed is unlikely to taper its purchases until around the end of the year, even as the U.S. budget deficit shrinks.
That’s in line with economists’ projections in an April 25-29 Bloomberg survey, taken before the Fed’s most recent meeting. The median estimate called for the Fed to reduce its purchases to a $50 billion monthly pace in the fourth quarter of this year and end them in the first quarter of 2014.
Among the Fed’s concerns with its exit is avoiding a repeat of 1994, when the central bank raised its target interest rate from 3 percent in January to 6 percent by early 1995, setting off an increase in bond yields that threatened the recovery from the 1990-1991 recession.
The yield on the 10-year Treasury climbed to more than 8 percent by November 1994 from as low as 5.57 percent in January of that year. Mortgage rates climbed from under 7 percent to more than 9 percent by year end.
In a March 1 speech, Bernanke said that improved communication from the Federal Open Market Committee about the plans for its target interest rates and bond purchases will help avoid a repeat of 1994.
“FOMC communication should both make policy more effective and reduce the risk that market misperceptions of the committee’s intentions would lead to unnecessary interest rate volatility,” Bernanke said, noting that in 1994, Fed communications were “very limited.”