This would be like a reverse Operation Twist.

By Wolf Richter for WOLF STREET.

Dallas Fed president Lorie Logan – a leading voice on the nuts and bolts of the Fed’s balance sheet due to her prior job as head of the New York Fed’s System Open Market Account (SOMA) which handles the Fed’s securities portfolio – gave another interesting and long speech on the nuts-and-bolts of central bank balance sheets. Most of the speech was dedicated to the nuts and bolts of balance sheet liabilities, primarily reserves. But at the end, she discussed assets – and how the Fed might change the composition of its assets after QT ends.

She had previously discussed this in more general terms, so we already could see the direction the Fed might be going with its balance sheet composition in the future after QT ends. But today, she discussed more of the nuts and bolts.

T-bills to take a greater share of Treasury holdings, to replace longer-term Treasury notes and bonds, to bring the Fed’s mix of Treasuries roughly in line with the mix of outstanding Treasuries. This would start after QT ends.

The minutes of the January FOMC meeting show the Fed discussed this and that “many” participants favored this move.

The Fed currently holds only $195 billion in T-bills, or 4.6% of its total Treasury holdings of $4.27 trillion. But of the total marketable Treasury securities outstanding, 22.5% are T-bills.

“At present, the Fed’s portfolio is significantly overweight longer-term securities and underweight Treasury bills,” Logan said in her speech today.

So after QT ends in the future and the Fed begins replacing all maturing Treasuries, “it would make sense in the medium term to overweight purchases of shorter-dated securities so as to more promptly return the Fed’s holdings to a neutral allocation.”

A “neutral allocation” would mean bringing T-bills up to a share of about 22.5% of its total Treasury holdings (assuming that ratio of T-bills to total Treasuries outstanding remains at 22.5% over the years), from 4.6% today, and reducing notes and bonds to a share of 77.5%, from 95.4% today.

To get this neutral allocation “more promptly,” the Fed would heavily favor T-bills over notes and bonds until it gets to the neutral allocation.

This would be a reverse Operation Twist. The classic Operation Twist was last used by the Fed in 2011, when it replaced T-bills with longer-term notes and bonds specifically to push down long-term yields as part of its interest-rate repression policy.

The move laid out by Logan today would be the opposite, shedding longer-term notes and bonds, and replacing them with T-bills. In theory, this would add some mild upward pressure on longer-term yields.

MBS are off the list entirely. Currently, MBS are the second largest asset on the Fed’s balance sheet, with a balance of $2.2 trillion [here is my discussion of the Fed’s QT through January].

Logan reiterated that in the future after QT ends, the Fed intends to hold “primarily Treasury securities” as assets, which the Fed has been saying for a year. Today, she explained explicitly what that meant: MBS are off the list of assets that the Fed intends to keep. And a “modest” share of loans and repos are on the list and would replace some Treasury securities.

This is the future list of assets as she spelled it out today:

• “Primarily Treasury securities,” so the big bulk of its assets
• Loans to the banking system, such as the classic Discount Window (the Fed is working on improving the system that Powell had called “clunky”). Currently $3 billion.
• Repos, in three ways:
  • Through the Standing Repo Facility (SRF), which Fed had revived in July 2021, after having shut it down in 2009 as QE had made it useless. Currently $0 balance.
  • Foreign and International Monetary Authorities Repo Facility, with which the Fed lends to other central banks. Currently $0 balance.
  • Fed’s Open Market Trading Desk’s repo operations, which it used in September 2019 when the repo market blew out and there was no SRF; and then again in March-June 2020.

Getting rid of MBS entirely might slightly widen the spread between mortgage rates and the 10-year Treasury yield, and would therefore lead to slightly higher mortgage rates than otherwise, the opposite effect of buying MBS whose purpose was to repress mortgage rates.

Repos and Discount Window loans might take a larger share of assets, to replace Treasuries.

Repos, especially overnight repos, provide an easy way to add liquidity and then drain it as overnight repos mature the next day, and if the Fed doesn’t replace them with new repos, they vanish off the balance sheet, and the liquidity vanishes with them; they don’t stick to the balance sheet like Treasury securities. Before the Financial Crisis, repos used to be the dominant asset on the Fed’s balance sheet.

In theory, increasing the share of repos and loans to replace longer-term securities might add some mild upward pressure on longer-term yields.

Here is what Logan said about it – note her idea about daily loan auctions:

“In the long term, in my view, it could be interesting to consider whether allocating a modest share of the Fed’s long-run balance sheet to loans or repos could improve the efficiency and effectiveness of policy implementation.

“For example, auctioning a fixed quantity of discount window loans each day could encourage banks’ operational readiness and demonstrate that borrowing is a normal activity for healthy firms.

“Such a facility might also smooth the redistribution of reserves around the banking system. The U.S. has about 9,000 banks and credit unions. Unexpected payment shocks can leave some of them short of reserves at the same time as others have a surplus. Frictions in interbank lending may slow the movement of reserves to whichever banks need them most. But if the Fed held a daily lending auction, the depository institutions most in need of reserves on any given day would likely place the highest bids, automatically redistributing liquidity away from firms with less need.”

Logan emphasized that shifting a larger share of the Fed’s asset to the Discount Window via loan auctions is not even being considered by the FOMC right now, “and even beginning to consider such a tool would require substantial conversation, analysis and learning from the experience of other central banks.”

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