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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As if the composition of the Feds balance sheet can make any long term difference on US economic prosperity ,)
These shifts would put some upward pressure on longer-term yields and mortgage rates. So not nothing.
Wolf
Won’t getting rid of mbs take dollars away from chasing houses
And this should drop house prices correct?
Less dollars chasing goods is a good thing
Indeed, taking away the safety net seems like a step in the right direction
I am a Real Estate professional. Here’s how I (and virtually all agents, be it brokers, their agents, builder’s agents) see this market.
I wouldn’t count on home prices coming down. The NAHB sentiment is very low, and according NAHB survey, after offering free points to lower interest rates and deep discounts, builders are “at the end of things that can be done”. Couple that with deportations of workers (or at least not allowing fresh construction work force to come in), inflation and tariffs, and the only option builders have to lower price is a close-out sale, followed by bankruptcy. While this would provide for a temporary drop in prices, right after it the prices would increase again due to a lack of new construction.
As far as existing home market, it’s near-dead. And I see it staying that way unless there’s a stock market crash or a deep recession, in which case investor tend to pile into bonds, lowering their price and hence mortgage rates.
Overall, this is the bottom in terms of what this market can take. Aside from someone here and there needing to relocate due to job or family changes, there’s not much room for growth. Even that has trickled down, with lots of accidental landlords being created, instead of sales. Their new renters additionally weaken the demand for sales, so there’s something maybe there, but I wouldn’t count as it’s relatively small.
So the mantra of the past 50 years (which I remember well) that home prices will come down in this weak market just doesn’t seem to have much, if any support, in the unique situation of today.
This is assuming that the U.S. Treasury also coordinates its policy with the Fed. If the Fed is not “inclined” to buy long term treasuries then the long term yields would probably reflect a realistic market demand.
Looks like Scott Bessent will have to continue issue T-bills.
Isn’t this simply a coordinated communication between Fed and Treasury? Bessent has already said he wants to eschew longer term securities and issue Bills; now the Fed says they want to purchase Bills. How convenient!
It’s actually not a matter of “convenient” but of “necessary” for there to be enough T-bills if the Fed wants to load up on $1-2 trillion in T-bills. There have to be enough T-bills for the Fed to buy. There is always lots of demand from the market for T-bills. And to take $1-2 trillion (15-30% currently) off the market like this is a huge thing, and it needs to be planned carefully, in terms of supply. And they will do that. They’re not going to starve the T-bill market.
@wolf – Could you please explain how would the 10y rates (and hence mortgage rates) go upward because of this ?
What I said is that they would be higher than otherwise. The reason is that the holdings by the Fed need to find another buyer, it’s a few trillions, so lots of new demand needs to materialize to buy them, and those additional buyers are generally lured into buying through higher yields. Higher yield creates demand. And you need a lot more demand to replace the Fed.
Trying to undo all that was done. Like Ferris putting the Ferrari in reverse.
Too little too late in my opinion. They ruined the economy for a huge amount of people and just shrug and continue onwards.
The miles coming off!
Push those long term yields up. Yin and yang let’s get to a more balanced (i.e., less market-interventionist FED) bond market. The 2008 and Covid debts need to be paid back, and now is a better time than ever. Keep it slow and steady FED. Congress, make those dang budget cuts and increase tax revenue. From my armchair after reading Wolf’s analyses it all seems so easy.
I would not be surprised to see the current administration push for the FED to start buying MBS again…if they haven’t already.
Sorry MC Bear, didn’t mean to respond to your comment, mine was meant as a general reply.
Wolf, do you see the 10 year staying above 5% for longer when this reverse operation twist starts?
The 10-year yield depends on inflation and inflation expectations, among other things. If inflation is back at ca 2% by then, the 10-year yield is going to be well below 5%. If inflation is at 5% or expected to be at 5% or whatever, the 10-year yields is going to be over 5%. These shifts here only put mild upward pressure on yields. Inflation puts a lot of upward pressure on yields.
1. As to “neutral allocation” — does the Treasury maturity book change much over time, and then “normalization” would require the fed balance sheet to adjust accordingly? In other words, is the Fed volunteering to be a slave to the treasury’s maturity schedule policy decisions?
2. If this is the way it is intended to work, are there negatives or unintended consequences to consider?
Not meaning to sound judgmental, just trying to understand.
Your #1. Back before 2009, the Fed’s assets were mostly repos and T-bills. Now the system has changed.
So the first goal is to get to a “neutral” composition. That’s going to require some heavy lifting over the years, given where the Fed is today. And that’s what Logan said today. That’s what they’re going to worry about.
Once they get there, the issue you pointed out will arise, and Logan addressed this too. If the Fed decides by then to maintain neutral composition, SHE thinks it might be a good idea over time to follow the Treasury issuance. This is years in the future.
Your #2: Yes, and I’m sure they’re fretting about them and overlooking the ones that are going to manifest themselves 🤣
” home price appreciation does seem to track very closely with bank reserves at The Fed (6mo lag)…”
Money matters. But some money matters more than others.
Thank you Wolf.
This is the best article I have seen on this particular area.
I do have concerns though.
Firstly; a move away from a perceived focus on long-term stability may open a box of unintended consequences; such as concerns about whether it is wise to allocate capital to long term projects if the ‘monetary authority ‘ looks to be moving to a reactive short term policy outlook.
Secondly; a move to what could be considered dancing around near term monetary conditions would require a deftness that has, so some might say, been lacking not just in the FED, but also a range of other central…. facilities.
Thirdly; the current administration may be only in play for 2 years. If the next mid-terms do not go as the current administration wishes, there may be what used to be known as an interregnum. Even if that does not occur, at 4 years from now the political outlook is unclear.
The last point is perennial argument. The creation of uncertainty in long term expectations, however, without the collective understanding of 2 or 3 post
war generations of what that might entail, could lead to unexpected outcomes.
Yes. Too bad we don’t have Rumsfeld anymore who put it so perfectly:
“…because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.”
I am not sure how you can know an unknown. However Rumsfeld is right about unknown unknowns, or simply unknowns. It is in every decent intro econometrics text, at the beginning, and then usually not mentioned again. A typical after the fact lament of a failed model “Oh, I should have included that variable, but I didn’t know about it.”
But I suspect many of the unknowns that should be in statistical models will never be known. It keeps people who try to make predictions humble (in the past they have had much to be humble about, as they say). It enables markets to be markets, where decisions are made without full information. If we knew all the variables that impact the economy and the future economy, life would be pretty boring.
You can know that you don’t know something. This is a problem but sometimes a solvable one. There a piece of data or intelligence that you don’t know, but you know it exists and maybe you can go find it out.
Unknown unknowns are the things you don’t know you don’t know. You didn’t even think of looking for that piece of information. These are the things that come to bite you in the ass because they were truly unexpected.
This is why Rumsfeld’s quote was fast more profound than everyone who laughed at it made it seem.
Why didn’t Rummy just say “We’re clueless.”
Because he became immortal by saying what he said?
All Logan talk is nice and right. But implementing will require backbone from FED Chair and FOMC members. So far Powell has shown courage to stand up against POTUS demands. After his term expires, what comes next? So all this will be depend upon next incoming chair.
FED can start this balance sheet calibration now itself. Anything above QT monthly limit goes to T-Bills only. Why to wait for QT end/slow down further? Time to Act is NOW. Isnt that a true test of this ambitious plan?
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Agreed in these times we must be vigilant–ever on the lookout for the unexpected…