Fed Will Unwind the Balance Sheet at an Awkward Moment
The playbook for U.S. Treasuries hasn’t changed much since the end of the Great Recession. First, traders come into a new year with a bearish bias, pushing up yields on the expectation that the conundrum of extremely low long-term rates will finally unwind as the economic recovery pushes on. Then, there’s a gradual capitulation as the global demand for Treasuries and disinflationary forces persist, driving yields lower in defiance of the Federal Reserve’s aggressiveness.
Things are about to change in at least one key respect -- the Fed will finally start unwinding its gargantuan $4.5 trillion pile of Treasury and mortgage securities in just a few months, convinced that the crisis-averting quantitative easing measure is no longer needed. The withdrawal of central bank support for the Treasury market will come at an inopportune time for the debt managers at the Treasury Department because of the outlook for rapidly growing budget deficits. That combination will put massive upward pressure on Treasury yields as the government ramps up bond sales. It won’t help that the European Central Bank is also starting to talk about pulling back.
Just two weeks ago the bipartisan Congressional Budget Office raised its 2017 deficit estimate to $693 billion, or $134 billion higher than their guess at the start of the year. The CBO’s estimates for 2018 through 2027 were bumped higher by a hefty $550 billion. With the Fed rolling over less of the proceeds from its maturing bond holdings into new securities, the Treasury will be forced to raise auction sizes quite dramatically over the next few years after a long period of stability. The prolonged era of acute Treasury shortages could come to a crashing halt -- and soon.
In preparing markets for the time when it starts to shrink its balance sheet, the Fed has emphasized that the retirement of its portfolio of Treasuries and mortgage securities in no way constitutes a major lever in their struggle to elevate long-term yields and that the level of the federal funds rate is what matters. In public comments, Fed officials have likened the tapering process to “watching paint dry” -- hoping no one pays much attention. In prepared remarks in advance of her semi-annual testimony Wednesday to Congress, Fed Chair Janet Yellen leaned more dovish. She said inflation is still running below target and rates won’t need to go up much to reach neutrality. That will encourage traders to bet rate hikes will be postponed until the balance sheet taper is well established.
Even the most bond-bullish Fed observers concede that the central bank will not be deterred in its effort to slowly shrink the balance sheet. Fed Governor Lael Brainard, a confirmed dove, said Tuesday that “it would be appropriate soon to commence the gradual and predictable process of allowing the balance sheet to run off.” The consensus in the markets is for the program to start sometime in the fall. The Fed has said it will allow a maximum of $6 billion Treasuries and $4 billion of mortgage securities to roll-off per month in the first quarter of the program, then raise the amount by $10 billion per month quarterly until the total hits $30 billion per month. That means if the program starts in October, only $18 billion in Treasuries would be retired this year, along with $12 billion in mortgage bonds.
That pace won’t make a dent -- at least this year -- in the ravenous global demand for high-quality sovereign debt. However, the totals quickly add up to some very large numbers, with 2018 estimates in the $220 billion range, followed by $270 billion in 2019 and $200 billion in 2020. Those kinds of numbers will have a major impact on Treasuries, as the private market must soak up all the new supply on its own. If this new source of pressure on long term rates comes as the Fed continues to push its three rate hikes a year scenario, the conundrum in bonds could finally be solved.
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