Why is the US Fed about to slow its bond offloading down?

The United States Federal Reserve has raised some questions recently, since it has decided to slow the pace at which it is shrinking its pile of over $4 trillion Treasury securities. For example: Is it merely preparing for an adjustment to the federal debt limit, or is it trying to avert a crisis in the US government bond market?

With apologies for dampening the drama, I’m going with the mundane explanation.

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Over the past couple of decades, the Federal Reserve’s holdings of Treasury and mortgage securities have played a crucial role in monetary policy. After the 2008 financial crisis, and during the global pandemic, its asset purchases—known as ‘quantitative easing’—pushed down long-term interest rates and increased the reserves that banks held at the Federal Reserve. Since March 2022, it has been unwinding that stimulus, allowing its holdings to run off gradually with the aim of reaching the level of reserves banks need to satisfy their liquidity needs, with a buffer above that for safety.

Now, though, the impending Congressional fight over raising the federal debt limit is making things complicated. When the government hits the limit, it can’t borrow to finance deficit spending. To make payments, the Treasury will have to draw down its balance at the Federal Reserve, potentially adding hundreds of billions of dollars in reserves to the banking system.

Later, when the US Congress agrees to increase the limit, as it always has, the Treasury will replenish its Federal Reserve account, depleting reserves at a rapid pace that—if the level drops too low—could force banks to scramble for cash.

The Federal Reserve doesn’t want a repeat of September 2019, when a shortage of reserves caused interest rates to spike. It considers the current supply to be well above “ample,” the level required to ensure that short-term fluctuations in reserves don’t destabilize rates, but it can’t know precisely how much banks will need.

Hence, out of an abundance of caution, to ensure that reserves remain plentiful as the Treasury rebuilds its cash balance, it’s adjusting the pace of its quantitative tightening. Beginning April, it will reduce the cap on the monthly runoff of its Treasury securities to $5 billion from $25 billion. The cap on mortgage securities will remain the same, at $35 billion (though the actual runoff has been slower, at about $15 billion a month).

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Granted, the Fed’s move will have a marginal impact on the US government’s borrowing needs. Once the debt limit is raised, the Treasury will have to issue slightly less debt to replace the smaller run-off from the central bank. But it’s a pittance in the context of a budget deficit running at roughly $2 trillion annually. It should have no bearing on whether bond investors will freak out about America’s fiscal outlook, which I agree is dire. The implications for monetary policy are also negligible.

Why, one might ask, didn’t the Fed just end the Treasury runoff completely? The $5 billion cap might represent a compromise to gain the broadest possible support (one official, Fed Governor Chris Waller, still dissented). Alternatively, it might signal that the runoff rate could be increased again if Congress raises the debt limit soon. I doubt that will happen: The deliberations will probably be lengthy, and the drain on reserves will be intense when the Treasury replenishes its cash at the Fed.

Could a shortage of reserves nonetheless destabilize markets? It’s not beyond the realm of possibility, but the risk is less than in 2019, because the Fed has established a standing repurchase facility where banks can borrow against their Treasury and mortgage-backed securities at the top end of the central bank’s target interest-rate range. Banks might balk at tapping the facility, for fear of being perceived as desperate. But if money-market rates spike above what the Fed offers, I’d expect any stigma problem to dissipate. After all, why wouldn’t you borrow at the lowest rate that is available?

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At some point, when there’s still a considerable margin above its estimate of banks’ desired reserves, the Fed will likely stop the Treasury runoff altogether. It’ll start reinvesting mortgage-security prepayments into Treasuries, maintaining the level of reserves needed to accommodate economic growth.

To achieve its goal of a Treasury portfolio that reflects the broader market, it’ll have to overweight purchases of short-term T-bills, which are currently under-represented (at only about $195 billion of the more than $4 trillion total). It’ll also move toward an all-Treasury portfolio, but very slowly: It’ll want to hold mortgage securities to maturity rather than booking the losses that selling would entail—and many of those securities still have at least 25 years to go. ©Bloomberg

The author is a Bloomberg Opinion columnist.