Fed Grip on $2.5 Trillion Treasury Stash Seen Firm for Years

  • Day of reckoning pushed off as bets on higher rates fade
  • Reinvestment policy linked with pace of target normalization

The One Thing the Fed Should Say, but Doesn't

The Federal Reserve’s liftoff from near-zero interest rates in December sparked angst over how quickly the central bank would start whittling down its $2.5 trillion hoard of Treasuries.

It turns out that investors in the world’s biggest bond market had little cause for concern. The weaker-than-forecast labor report for May wiped out bets that policy makers would follow up on their year-end move and raise rates when they meet Tuesday and Wednesday. What’s more, traders now see less than a 50 percent chance of the next increase coming this year.

The shift in expectations is significant because New York Fed President William C. Dudley said in January that officials anticipate keeping the holdings stable until normalization of rates is “well under way,” though he said there was no specific level for the Fed’s target at which reinvestment would end. For bond bulls, confidence that rates will stay lower for longer means one less reason to worry about owning Treasuries with yields approaching record lows.

“It’s safe to say that not only is ending reinvestment further off the radar, it’s not even on the radar,” said Brian Svendahl, Minneapolis-based senior portfolio manager of fixed income at RBC Global Asset Management, which oversees about $290 billion. “There is certainly no urgency now.”

Plans Clarified

Officials made clear well over a year ago that they had no plans to sell any of the debt on the Fed’s balance sheet, accumulated in a bid to support the economy after the financial crisis. Instead, they’d look to reduce holdings eventually by halting reinvestment of principal payments as bonds came due. Under current policy, the Fed will plow about $216 billion of proceeds from maturing securities into new Treasuries over the course of this year. Next year, the central bank has $194 billion maturing, followed by $389 billion in 2018. The Fed is the biggest holder of the government’s debt.

QuickTake The Fed Lifts Off

With more than $8 trillion of sovereign debt worldwide carrying negative yields, the Fed may find plenty of demand if it opts to unload some of the Treasuries and mortgage-related securities on its books, according to Christopher Low, chief economist at FTN Financial in New York.

“Allowing some QE holdings to roll off when the market’s appetite for longer-term debt is strong would give the Fed more room to act in a future crisis while restoring some yield for investors,” Low said in a note Tuesday.

‘Reasonable Level’

A year ago, Dudley said he’d like to see rates rise to a “reasonable level” before ending the rollover policy. Such action by the Fed would amount to additional “tightening of monetary policy” and should come only when the funds rate was at about “1 percent, or 1.5 percent,” he said.

At the end of 2015, most policy makers anticipated reaching that range within 12 months. Fed officials’ median forecast in December was for the policy rate to rise to 1.375 percent in a year. The projection for the end of 2016 fell to 0.875 percent as of March.

Futures traders see a much slower path. The implied probability of another quarter-point increase this month has fallen to zero, from 22 percent on June 2, the day before the release of the May payroll data. The chance of a rate boost by year-end has dropped below 50 percent. The effective funds rate, now at 0.37 percent, won’t reach 1 percent for at least another three years, overnight index swap data compiled by Bloomberg show.

Playbook Tossed

“Whatever playbook the Fed had, I think they’ve torn it up,” said Thomas Graff, who manages $4 billion of debt at Brown Advisory Inc. in Baltimore. “The consternation around the first hike last year plus the consternation ahead of the second hike means maybe things have changed. So I don’t want to be doing anything that relies on strategy of the world’s central banks.”

In April, primary dealers expected it would take 18 months for the Fed to change its reinvestment policy, at which point the funds rate would be in a range from 1.25 percent to 1.5 percent, according to the median response to a survey by the central bank.

“You really don’t need to worry about this now,” said Svendahl at RBC Global Asset Management.

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