Fed Balance-Sheet Plan Missing Key Detail Tied to Bond Squeezes

(Bloomberg) -- The Federal Reserve has been painstaking in laying out how the upcoming reduction in its $4.5 trillion balance sheet will work but left one key detail out: What will it do with the money it will continue to reinvest?

With the drawdown slated to start off slowly, the Fed initially will be reinvesting a bigger proportion of its maturing bond holdings than it will be allowing to run off. So its decision on how to redeploy that cash will have important ramifications for investors, with the risk that liquidity problems known as squeezes arise in longer-dated Treasury securities depending on what the Fed opts for.

“As far as the mechanics go, this seems to be the last question outstanding” on the balance sheet, said Mark Cabana, head of U.S. short rates strategy at primary dealer Bank of America Corp. in New York. “If the Fed were to make a material adjustment to its reinvestment policy, that would have an impact.”

Central bank Chair Janet Yellen and her Federal Open Market Committee colleagues are likely to talk over the issue at a two-day policy making meeting beginning Tuesday that's widely expected to end with no change in interest rates.

Fed watchers surveyed by Bloomberg last week expect the FOMC to wait until September to announce the start of its balance-sheet drawdown. They assigned just 13 percent odds to the possibility that such an announcement will come this week.

The Fed currently does not actively manage the duration of its reinvestments, simply allocating its bids proportionally to the amounts that the Treasury offers through its public debt auctions.

Up for discussion is whether it should change that strategy as drawdown begins and allocate more of its maturing money to shorter-dated Treasury securities. The aim would be to speed up the eventual return of its balance sheet to more normal levels, both in terms of size and duration, thus reducing the Fed's footprint in the bond market.

Backstop Role

The trouble is that would also restrict its ability to act as a market backstop because it would not have longer-dated, on-the-run Treasuries to lend out from its System Open Market Account, which is the Fed's name for its portfolio of assets.

“You'd have more technical squeezes” in the repurchase market, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. That might be particularly the case for the widely traded 10-year note.

When a trader short-sells a Treasury security with the hope that its price will fall and it can be bought back later more cheaply, they will typically need to “borrow” it from a third party via the repo market or from the Fed. When there is a lot of short selling in a particular security, and reduced supply available in repo or from the Fed, it can create a so-called short squeeze where prices are driven higher as it becomes harder to obtain. In that case, uncompleted trades, known as fails, often soar.

Bank of America's Cabana echoed Crandall's comments. “It would lead to greater specialness in longer-dated issues, particularly 10- and 30-year bonds” as there would be no supply available from the Fed to meet any exceptionally big demand in the market, he said. “Overall market liquidity might suffer to some extent.”

Officials at the New York Fed highlighted the importance of the SOMA to the market in a blog post last August.

“The Fed's securities lending program helps alleviate security supply shortages and mitigate settlement fails,” they wrote. But, they added, “its effects are limited by the size and composition of SOMA holdings relative to market demand to borrow specific securities.”

Monthly Caps

Policy makers have said they want to begin paring back the central bank's massive holdings of Treasury debt and mortgage-backed securities this year, though they have yet to set a specific starting date.

The monthly reductions will initially be capped at $6 billion for Treasuries and $4 billion for housing-related debt, before gradually increasing to $30 billion for Treasuries and $20 billion for housing debt.

Some $89.7 billion of the Fed's holdings of Treasuries mature this year while $425.6 billion come due in 2018.

Cabana is betting that the central bank sticks with its current reinvestment strategy and does not seek to further shorten the maturity of its asset holdings.

“They are going to experience a pretty notable shortening in the overall duration of the portfolio just as it is” as they reduce the balance sheet, he said. “I don't know if they would necessarily want to accelerate that.”

Crandall, though, is unsure which way the Fed will go.

“On the one hand, preserving the status quo always has a certain appeal, as there is less chance of a messaging mishap,” he wrote in a July 24 note to clients. “At the same time, however, we suspect that many FOMC members would like to return to a more conservative balance sheet as well as a smaller one.”

--With assistance from Alexandra Harris and Liz Capo McCormick

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net.

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Alister Bull