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How will the world’s largest bond portfolio be managed?

Minutes of the May Federal Open Market Committee released this week provide hints. While most Fed watchers offered guesses about the size and timing of the unwinding of the central bank’s $4.5 trillion balance sheet, the composition of the System Open Market Account generated scant discussion.

The more familiar monetary-policy question—the timing of further increases in the central bank’s key federal funds target—got most of the attention. That’s even though the probability of a 25-basis-point (one-quarter percentage-point) hike, from the current 0.75%-1% range, at the June 13-14 FOMC meeting was close to 100% certainty, according to Bloomberg’s analysis of fed funds futures. While the consensus of Fed watchers calls for another boost by year-end, the futures market continues to put that probability just short of 50% (48.9%, to be exact.)

But more interesting was the final paragraph, which discussed how the Fed’s assets could be pared by simply allowing maturing issues not to be rolled over into new issues. (Quick review: When a central bank expands its asset holdings, it adds funds to the banking system, and vice versa.)

Letting securities simply mature as they come due is functionally equivalent as the Fed selling them outright. Since the Fed wouldn’t be reinvesting in the new Treasury or agency security, the public would have to pony up for the new issues. All else being equal, the increased supply of new securities means lower prices and higher yields.
The purchase of $600 billion of securities during the Fed’s “quantitative easing” program had the effect of about a 75-basis-point cut in the fed funds rate, according to a Fed estimate cited by Morgan Stanley.

So, a $300 billion reduction in the Fed’s portfolio over four quarters would be functionally equivalent to about a 35-basis-point hike in the funds rate, the bank said in a research note.

The FOMC minutes discussed a system of “caps” in the volume on the dollar amount of Treasury or agency securities that would be allowed to run off each month. That cap would start and low levels and be adjusted every three months, according to proposed scheme.

Morgan Stanley’s team hypothesized the Fed could start shrinking its balance sheet in the fourth quarter, with redemptions of $5 billion each month in Treasuries and agency mortgage-backed securities. In each successive quarter, those caps would be increased by $5 billion apiece, to $10 billion in the first quarter of 2018, $15 billion in the second quarter and $20 billion in the third quarter.

The big question is when to start the process would start. The minutes showed the panel expected to begin shrinking the central bank’s securities holdings this year, provided the economy continued to grow and the fed funds rate rose as expected,
Beyond the Fedspeak, let’s speculate how things could unfold. JP Morgan economists postulate the Fed could begin by capping Treasury redemptions at $8 billion a month and agency MBS at just $4 billion, so the Fed reduces its mortgage holdings more gradually.
In other words, the composition of the Fed’s redemptions isn’t set in stone. By extension, neither are the securities buys when it does reinvest.
The Fed has a history of trying to manipulate the yield curve by adjusting its holdings. In QE2, the second phase of its quantitative easing in 2011, the Fed swapped shorter-dated securities for lengthier maturities. The aim was to bring down longer-term interest rates to help boost housing.

What if the Fed decided it wanted a more steeply sloped yield curve? That would be helpful to banks by boosting their net interest margins and likely encourage lending.

Alternatively, if rising rates were to hamper housing, perhaps the Fed could continue to roll over MBS to support the mortgage market and let more Treasuries run off. In the longer run, however, the Fed would prefer to get back to owning primarily Treasuries. (As of Wednesday, the Fed held $2.46 trillion of Treasuries and $1.78 trillion of agency MBS.)

It will be interesting to see how the Fed shrinks its portfolio, a process that will stretch out well into the next decade. And how that interacts with the administration’s spending and borrowing plans may be even more interesting.

In any case, the Fed has been anything but a passive observer since the financial crisis. Even as it unwinds its post-crisis policies, it will be an active participant in the market.