The Fed’s Long Unwinding Road

The Fed’s Long Unwinding Road

The Fed’s disinvestment program introduces caps for maturing USTs and mortgage-backed securities (MBS) to limit the size of redemptions per month (the amount beyond the cap would be reinvested). According to the disinvestment scheme, the caps will start at US$6 billion for USTs and US$4 billion for MBS, and would rise in equal steps every three months, until they reach US$30 billion for USTs and US$20 billion for MBS (by October 2018).

Exhibits 1 and 2 present a static profile for USTs and MBS while ignoring the reinvestment issue. In order to generate runoff projections, we have to make additional assumptions on how the Fed reinvests maturing USTs and MBS and how other components of the liabilities part of the balance sheet evolve.3

If everything goes according to plan, by 2020 the majority of the tightening will have been achieved. While the actual trajectory remains uncertain, the Fed’s balance sheet would shrink by US$1.3 trillion over the next three years, with Treasuries and MBS redemptions in 2018–2020 totaling US$700 billion and US$630 billion, respectively.

Whatever the end point, the Fed hopes this unwinding will have little market impact, if any.4 Most investment banks’ analysts seem to agree, and project only a modest increase in yields, with the 10-year UST yield rising by around 50 basis points.

Quantitative Tightening II: Who Will Buy What the Fed Won’t Buy?

The simplest (and safest) scenario would be for the Treasury to reduce the outstanding level of public debt correspondingly: The Treasury would transfer money from its cash account at the Fed to cover the maturing debt. An equal amount would be removed from both sides of the Fed’s balance sheet, which would shrink by the amount of debt maturing. This, however, can only happen if the stance of fiscal policy results in a fiscal surplus, allowing a reduction in the debt level. In practice, Treasury issuance will likely rise substantially over the next few years.

The Treasury will need to issue new securities to cover those maturing (plus additional ones to finance the deficit). The new securities could be purchased by the domestic public or by domestic financial institutions, or by foreign buyers.

Consider domestic buyers first: To be induced to increase their demand for USTs, both financial institutions and individuals will need to be enticed by a lower price, i.e., a higher yield. From a bank’s perspective, USTs are not the same as cash reserves. USTs carry much higher duration risk, which a bank can hardly ignore especially in an unwind scenario.

Proponents of the savings glut theory say less price-sensitive foreign investors will step in. The data, however, shows the opposite: Demand for perceived safe-haven assets has waned, though it has been concealed by the effects of QE across the major advanced economies.

Our model therefore shows that even if demand from foreign official buyers recovers somewhat after being absent for the last four years, a much larger share of UST supply would need to be absorbed by price-sensitive investors, including private foreign buyers but especially domestic investors like banks, mutual funds and pension funds. This would significantly increase the likelihood of sharp snapbacks in yields. This transition could be exacerbated by negative feedback loops as players reassess their interest-rate forecasts.5 This analysis implies that even if US economic activity holds at current lackluster levels and inflation pressures remain subdued, the Fed’s unwinding should trigger a meaningful rise in bond yields.

The Liabilities Side: The Return of the Money Multiplier

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