The “danger zone” referenced in the chart above by Lewis Alexander of Nomura is a kind of arbitrary area between the Fed’s owning 50 per cent of the outstanding stock of Treasuries in a certain category (and thus potentially starting to affect market liquidity) and the 70 per cent threshold at which the SOMA desk will stop buying outright.
As you can see, it will be a little while yet before the Fed approaches that threshold, even if it increases purchases to $65bn a month.
And the Fed also has the option to shift its purchases along the curve if chooses to:
(The chart assumes that Treasury purchases are increased to $65bn.)
Further commentary from Alexander:
The Fed still has plenty of room to purchase in the UST market as a whole, even if it increases monthly purchase to $65bn. If we do not assume the bucket allocation shifts higher, the Fed would not own a significant proportion (>50%) of the overall available for purchase USTs (greater than 4yr sector) until the end of 2015, and will only reach 70% if purchases of $65bn a month extend well into 2017.
It’s important to note one caveat, which is that since this note was released earlier this month, the outlook for the US fiscal situation has improved because of increased tax revenues and a surprisingly high forthcoming remit from Fannie Mae and Freddie Mac. Thus the overall stock of outstanding Treasuries will be somewhat lower than assumed above, though the impact likely won’t be so great as to change the dates by more than a few months.
The same issue with MBS purchases is a little more complicated because the Fed buys in the To-Be-Announced market, and of course the pace of agency MBS issuance can vary depending on conditions in the housing market. For a helpful overview of these complications and how the NY Fed deals with them, we would recommend Simon Potter’s recent comments.
As for the possible problem of the Treasury’s having to roll over the debt that the Fed allows to roll off and find new buyers for its new issues, we largely agree with the conclusion of a recent Goldman note looking at same (full note in the usual place):
To the extent the Fed’s balance sheet will not remain elevated forever, one way to think about the Fed’s behavior during QE is that it delayed, rather than ultimately prevented, Treasury issuance (and hence duration risk) from ending up in the hands of private investors.
In the Fed’s view, this has likely prompted investors to temporarily “portfolio rebalance” into riskier assets than they otherwise would have chosen, resulting in easier financial conditions. The effect of these policies would then be expected to dissipate gradually over time, as market expectations for the time path of the Fed’s balance sheet shift. We tend to agree with the Fed’s assessment that the stock effect of purchases dominates the flow effect.
As such, we do not expect the large drop off in Fed purchases as a share of net issuance in 2014, or the well-telegraphed shrinkage of the Fed’s Treasury portfolio holdings beginning in 2016, to result in a disorderly selloff in fixed income, just as the end of QE2 in June 2011 did not result in a disorderly selloff.
We’ve written in the past about other potential market disruptions from QE. Some of them — liquidity problems in auction markets, delivery fails — have failed to materialise, and seem unlikely to. But we still think QE does have a distorting effect on collateral markets. This is somewhat offset by the Fed’s paying of interest on reserves, which acts as a kind of sterilising safe asset for the dealers. It isn’t available to non-depositary institutions, though that may soon change.
We could well be wrong, but it’s hard for us to avoid the same conclusion we (and many, many others, including Ben Bernanke) have been reaching for several years now, which is that it remains an outrage for fiscal policy to have tightened so much so quickly.
There are nuances involved, of course, but looser fiscal conditions wouldn’t just help the economy recover more quickly; they would also help satisfy collateral requirements in lending markets and, by lifting rates up off the zero bound more quickly, render moot some of the debate over unconventional monetary policy and its relationship to financial stability.
And if you’re of the NGDP level-targeting persuasion… yes, ongoing QE would be sending a more potent signal if the Fed continued moving in that direction. We agree.
UPDATE: The CBO announced Tuesday that it was cutting the projected deficit for the US in 2013 by nearly $200bn, and over ten years by $600bn. If the fiscal picture continues to improve, then it might have more of an influence on the outstanding stock of Treasuries than we had anticipated.
Related links:
Revisiting monetary transmission – FT Alphaville
Stability and the Fed – FT Alphaville
Frantastic? – FT Alphaville
Exiting unconventional policy will be unconventional – FT Alphaville