Fed VP Stanley Fischer commented on SOMA maturities in his speech last Friday, but it appears very few have taken notice as yet and even fewer comprehend the challenge soon confronting The Fed.
Many believe that Twist had pushed maturities farther “into the future”. The “future” is Q1 2016. (Note: a shrinking balance sheet is a defacto tightening)
Via Scotiabank's Dov Zigler,
With more than USD 200bn of Treasury securities held by the Fed due to mature in 2016, the Fed will have to make meaningful monetary policy choices in advance.
The Federal Reserve has expanded its balance sheet tremendously since 2008, bringing it from USD 900bn in August 2008 to USD4.5tn today. The balance sheet expansion also involved an extension of the weighted average maturity of the Federal Reserve’s System Open Market Account (SOMA), accomplished by purchasing longer-dated Treasury securities outright via Large Scale Asset Purchase programs (popularly called ‘quantitative easing’) as well as via a maturity extension program whereby the Fed sold securities with maturities of fewer than three years to buy securities with longer maturities (so-called ’Operation Twist’). As a result of the latter process, by which the Fed sold essentially all of the Treasury securities that it held with maturities of three years or fewer by the end of 2012, the SOMA has not experienced meaningful maturity of Treasury securities from 2013 probably throughout this year. During this period, the Fed also pledged to reinvest principal from maturing mortgage backed securities (MBS) on its balance sheet, which prevented the SOMA from shrinking — a process which the Fed has continued. Even once the Fed completed its asset purchases in November 2014, it therefore still found itself able to remain on a fairly accommodative auto-pilot as its balance sheet was not (and is not) meaningfully contracting.
The Numbers
This state of affairs will not continue indefinitely. As shown in the chart to the right, USD 210bn of Treasury securities mature in 2016, with roughly two-thirds of that amount maturing during the first part of the year. This implies that the Federal Reserve will have to make decisions about the trajectory of monetary policy between now and the start of 2016 — indecision would be a difficult and increasingly unpalatable option, itself tantamount to a decision to tighten monetary policy as the Fed’s balance sheet would shrink.
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Indeed, by doing nothing, the balance sheet would contract by as much as USD 1.1tn through 2019 just through Treasury security maturity. (As the Fed’s large portfolio of MBS mature/prepay, should the Fed stop reinvesting, this number could easily exceed USD 2tn by then — the SOMA currently contains MBS with a face value of USD 1.7tn)
Option 1: Reinvest at Low Duration
Of course, it’s not as though maturing Treasury securities in the SOMA prevent the Federal Reserve from maintaining an accommodative policy or for that matter assuredly impede Fed policy options. Treasury securities matured regularly even as the Fed was expanding its balance sheet, i.e. prior to the Fed’s completion of Operation Twist. Reinvestment of maturing securities was a regular Fed activity when the Fed maintained a still sizable balance sheet (consisting almost entirely of shorter duration securities) prior to the crisis. The difference now is that the sheer volume of maturing securities is much larger. With just over USD 400bn of securities in the SOMA due to mature in 2016-17 (and USD 142bn maturing during the first six months of 2016), the Fed would find itself ‘rolling’ a very substantial quantity of securities by the end of 2017 should it follow this program. By the end of 2018, when the largest maturities from the SOMA begin, the Fed would find itself rolling more than USD 1tn of securities — not a particularly appealing policy choice and one that would chew up a large share of the generally maintained quantity of securities outstanding with maturities of 1 year or less (see chart 2).
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One way of mitigating this would be via lending shorter-dated securities out as part of the Fed’s reverse repo program, but this would still lead to an increasingly cumbersome and involved role for the Fed in the shorter-run Treasury market.
Option 2: Shrink the Balance Sheet
Which raises the more realistic possibility that the Fed will begin to stop reinvesting maturing Treasury security principal at some point in the next couple of years, and quite possibly in early 2016. The so-called order of operations for Fed policy normalization is supposed to begin with rate hikes prior to allowing maturing securities in the SOMA to run off, hence shrinking the Fed’s balance sheet. This is not to say that all maturing principal need not be reinvested: for instance, the Fed could seek to allow principal to run-off in an orderly fashion by announcing a monthly amount of balance sheet run-off and managing its security portfolio accordingly. Regardless of the method decided upon, the process of balance sheet run-off will be an integral aspect of the Fed’s eventual gradual rolling back of the stimulus provided during the crisis, a subject touched on most recently by Fed Vice Chair Fischer in his remarks on “Conducting Monetary Policy with a Large Balance Sheet” [13].
Option 3: Reinvest at Current Weighted Average Maturity/Let’s Twist Again
Of course, the Fed maintains an option in terms of incremental easing should the economy go south: it has the ability to reinvest maturing securities at a distribution that matches or is similar to the current composition of its balance sheet, i.e., it can conduct something analogous to 2012’s maturity extension program and buy longer-dated securities.
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This seems like an unlikely path for the Fed given the very large share of the longer-dated Treasuries market that it already holds (see chart 3) and estimated impact that these holdings are having on Treasury term premia (the Fed estimates an impact of more than 100bps for the benchmark 10-year Treasury note according to the speech by Vice Chair Fischer cited above). Despite the unlikelihood of a third shot at operation twist this decade (‘let’s twist again?’), maturity extension is a tool and an option that the Fed retains if, for some reason, it were to decide to further lean on U.S. term premia.
Conclusion: Even Indecision is a Choice
Monetary policy in the U.S. is, of course, not on a preset course, and, as the FOMC tells us regularly, is subject to incoming economic data and the FOMC’s assessment of economic conditions. However the SOMA is on a preset course to contract unless the FOMC decides to do something about it — the FOMC needs to make decisions in the coming nine months. If the FOMC were to wish to maintain an accommodative policy indefinitely, it would have to either gain comfort with holding a very large share of short-term Treasury securities or engage in a variant of its maturity extension program. A more likely alternative is the eventual normalization of the balance sheet’s size probably in a fashion that avails itself of the run-off of the Fed’s holdings of securities — which starts to happen of its own volition next year, thereby necessitating choices in the coming months.
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And here is a graphical representation of why this shoould matter to every equity market investor...
The heroin drip hits zero pic.twitter.com/ZVdgjn34N0 [15]
— Not Jim Cramer (@Not_Jim_Cramer) March 5, 2015 [16]
