Fed s Quantitative Tightening : Fixed Income Implications Mikael Olai Milhøj Senior Analyst, International Macro Research +45 45 12 76 07 milh@danskebank.com Mathias Røn Mogensen Analyst, Fixed Income Research +45 45 13 71 79 mmog@danskebank.dk 6 April 2017 Investment Research www.danskebank.com/ci Important disclosures and certifications are contained from page 24 of this report
Contents Summary (page 2) - Expected FI implications Background (page 3) - Fed likely to start quantitative tightening in Q1 18 Market consensus (page 4) Reducing the balance sheet (page 5) - A medium-term issue Reducing Fed s holding of MBS (page 6-10) - supply and demand factors Reducing Fed s holding of Treasuries (page 11-14) - supply and demand factors Risk of unwarranted financial tightening (page 15-17) Appendix (page 18-23) 1
Summary - Expected FI implications Reduction of Fed s balance sheet (SOMA) Reducing Fed s holding of MBS Reducing Fed s holding of Treasuries Increased interest rate volatility Wider Treasury ASW spreads Modest Treasury yield curve steepening pressure Treasury yield curve steepening pressure Neutral to tighter Treasury ASW spreads Risk of unwarranted financial tightening Lower long-term Treasury yields through lower inflation expectations Wider FRA/OIS spreads Wider Treasury ASW spreads 2
Background Fed likely to start quantitative tightening in Q1 18 After the March Fed hike, we expect the Fed to hike twice more this year (July and December), see FOMC review: Fed says it is on track, not more hawkish, 15 March. The Fed s current reinvestment strategy is to continue reinvesting principal payments until the normalisation of the Fed funds rate is well under way. In the FOMC minutes released yesterday, it said that a change to the Committee s reinvestment policy would likely be appropriate later this year, provided that the economy continued to perform about as expected, see also FOMC minutes: Quantitative tightening is moving closer, 5 April. We still expect the Fed to begin quantitative tightening in Q1 18 (when the Fed funds rate will be in the range of 1.25-1.50%, i.e. halfway the long-term neutral rate at 3.00%, according to the latest projections) although risk is skewed toward earlier (possibly in December). Consensus both among investors and analysts was mid-2018 in the most recent surveys. We think an announcement on what could trigger quantitative tightening is likely in connection with the June meeting. The participants also discussed whether the timing of quantitative tightening should be based on a quantitative threshold or on a qualitative judgement. Several participants prefer the former meaning that quantitative tightening would be likely to depend on the Fed funds target range or the level of an economic variable (possible the PCE inflation rate or the unemployment rate, as it was the case with the Evans rule). As we wrote in Research US: Fed s regulatory hurdle for starting quantitative tightening, 13 March, rising demand for currency, a change in US treasury cash balance policy and financial regulation limit the scope for a reduction of the balance sheet. An optimistic scenario would amount to a USD1,700bn total balance sheet reduction carried out as a USD30bn per month reduction over a five-year period. It may be too optimistic and if the Fed attempts quantitative tightening of this magnitude, it could lead to an unwarranted tightening of USD liquidity. 3
Market consensus As mentioned in the previous slide, we expect the Fed to start quantitative tightening in Q1 18 when the Fed funds target range is 1.25-1.50% although risk is skewed towards earlier (possibly in December). Looking at the consensus among analysts, the latest Bloomberg survey finds that most analysts expect the Fed to begin shrinking its balance sheet in Q2 18 when the Fed funds rate is somewhere in the range of 1.50-2.00%. It is difficult to extract market expectations but according to the latest New York (NY) Fed primary dealer survey, the primary dealers expect the Fed to begin shrinking its balance sheet when the Fed funds rate is 1.375% around mid-2018. In the NY Fed primary dealer survey participants were asked: * What is your estimate for the most likely level of the target federal funds rate or range if and when the Committee first changes reinvestment policy? ** What is your estimate for the most likely timing (in months forward) of a change to the Committee s policy of reinvesting payments of principal on Treasury and/or agency debt and MBS? Level of Target Fed Funds Rate/Range* Treasuries Months Forward** Agency Debt and MBS 25th Pctl 1.13% 12 12 Median 1.38% 17 17 75th Pctl 1.38% 18 18 Note: Results as of January/February 2017 Source: NY Fed Primary Dealer Survey 4
Reducing the balance sheet - A medium-term issue 500 Par Value (USD bn) 450 400 350 Fed s bond portfolio System Open Market Account (SOMA) 4.237bn 3% 0% 0% 42% 300 250 55% 200 150 100 50 0 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043 2045 2047 Maturity Agencies FRN MBS Notes and Bonds TIPS Note: current face value used as par value for MBSs Source: Federal Reserve, Danske Bank Markets, 22 March 2017 data The latest minutes indicate that the FOMC members generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS. In the following, we assess some of the potential fixed income implications from: Quantitative tightening as a reduction of the holdings of mortgage bonds. Quantitative tightening as a reduction of the holdings of Treasuries. The risk of an unwarranted financial tightening. 5
Reducing the Fed s holding of MBS supply and demand factors
Fed s MBS holding - The build-up, maintenance and a feasible reduction The MBS holding in SOMA currently constitutes around USD1,780bn. This is a static buy and hold position, i.e. no interest rates risk hedging. Development in Fed s MBS holding Monthly change in MBS holding, USDbn According to the New York Federal Reserve only fixedrate agency MBS securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are eligible assets for agency MBS reinvestments. Eligible assets include, but are not limited to, 30-year and 15-year securities. An estimate of the yearly prepayment rate in the portfolio is 15.11% (this is a face value, weighted generic 12-month constant prepayment rate (CPR) based on the experience of a generic aggregation of similar mortgages). This suggests a simplified estimate of the yearly/monthly prepayments of USD265bn/USD22bn. That said, the actual prepayment rate is likely to be dependent on the interest rate level going forward, i.e. there are usually fewer prepayments in a fixed income bear market and vice versa in a bull market. In addition, as the bonds are annuities, the borrowers repay scheduled principals during the bond s life as well. Hence, the Fed could in fact reduce its balance sheet markedly by phasing out or ceasing reinvestments of the MBS prepayments and/or scheduled repayment of principals. Source: Federal Reserve, Danske Bank Markets Note: The reported estimate is based on Bloomberg s Prepayment Model 7
Fed s MBS holding - The portfolio interest rate risk An estimate of a face value weighted duration and convexity of the Fed s MBS holding is 5.08 and -1.36, respectively. The interest rate risk of the MBS holding is concentrated in the 5Y-20Y segment with the 10Y tenor being the most exposed. Phasing our or ceasing MBS reinvestment in SOMA is a de facto shift in MBS holdings from the Federal Reserve towards investors. Whereas the Federal Reserve s MBS holding is a static buy and hold position, a gradual shift towards investors will likely result in a more interest rates risk hedged position. Interest rate risk concentrated in the 5Y-20Y segment Face value weighted delta vector of MBS in SOMA, Bpv 1.40 1.20 1.00 0.80 0.60 0.40 0.20 Bpv Interest rate risk concentration 0.00 1y 2y 3y 5y 7y 10y 20y 30y Source: Federal Reserve, Bloomberg, Danske Bank Markets Note: All reported estimates are based on Bloomberg s Prepayment Model 8
Reducing Fed s holding of MBS - 5Y and especially 10Y Treasury ASW spreads likely to widen In our view, this could add to an Treasury ASW spread widening in the 5Y tenor and especially the 10Y tenor as: Payer (hedging) demand in interest rate swaps, which reflects credit risk compared to Treasuries, is likely to increase. Particularly in the 5Y-20Y (10Y) segment where the interest rate risk is concentrated. The added negative convexity to the market will likely increase interest rate volatility in general. However, if mainly swaps are used to hedge the new interest rate risk, these interest rates will be affected the most. This could increase the term (volatility) premium embedded in interest rate swaps compared to Treasuries. Negative convexity illustration in callable bonds The price of a callable and non-callable bond, USD Price Yield Par Callable Non-callable Source: Danske Bank Markets 9
Reducing Fed s holding of MBS - 5Y and especially 10Y Treasury ASW spreads likely to widen If the Federal Reserve was to reduce its holdings of Treasuries or Ginnie Mae mortgage bonds (the latter amounts to around USD410bn in SOMA) it would essentially be swapping one type of level 1 HQLA (supply of reserves) for another type of level 1 (the bonds). Inverse Treasury ASW curve with 10Y normalising Treasury ASW spreads, bp However, if the Federal Reserve was to reduce its holdings of Fannie Mae (around USD850bn in SOMA) or Freddie Mac mortgage bonds (around USD515bn in SOMA) it would be exchanging level 1 HQLA for level 2A HQLA. The latter has a haircut of 15% and is only allowed to comprise 40% of banks HQLA. Hence, phasing out or ceasing reinvestment of Fannie Mae or Freddie Mac mortgage bonds would intensify the relative LCR demand versus supply of Treasuries adding to a Treasury ASW spread widening pressure. As a consequence of the mentioned market implications and the current consensus amongst analysts and primary dealers, the spill-over to Treasury yields from a reduction in the Federal Reserves balance sheet by phasing out or ceasing reinvestments of MBS principal payments should, in our view, be modest. Besides, a too excessive quantitative tightening could lead to temporary tightening of financial conditions, offsetting a potential steepening pressure, see slide 17. Source: Bloomberg, Danske Bank Markets 10
Reducing Fed s holding of Treasuries supply and demand factors
Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Fed s Treasury holding - Maturity profile and a feasible reduction The Treasury (Notes, Bonds, FRN and TIPS) holding in SOMA currently constitutes around USD2,445bn. According to the New York Federal Reserve, Treasury rollovers in SOMA are conducted by replacing maturing holdings with securities issued at Treasury auctions. They are typically accomplished by placing bids for SOMA at Treasury auctions equal in par amount to the value of the holdings maturing on the issue date of the security being auctioned, allocated proportionally across those securities by announced offering amount. Bids at Treasury auctions are placed as non-competitive tenders and are treated as add-on to the announced auction sizes. For a hypothetical example, see slide 19. Maturity outlook until end-2018 Par value of maturing Notes, Bonds, FRN and TIPS, USDbn 70 60 50 40 30 20 Par Value (USD bn) As indicated by the maturity profile of Treasury held in SOMA, the Fed could solely cease reinvestments of maturing Treasuries and still be able to reduce its balance sheet markedly. Indeed, maturing Treasuries in 2018 amounts to nearly USD425bn. 10 0 2017 2018 Hence, if for example a balance sheet reduction is carried out as a USD30bn per month Treasury reduction, the Fed would still need to conduct some reinvestments of Treasuries during 2018. FRN Notes and Bonds TIPS Source: Federal Reserve, Danske Bank Markets, 22 March 2017 data 12
Reducing Fed s holding of Treasuries - Yield curve steepening pressure, but no taper tantrum Phasing out or ceasing reinvestment of maturing Treasuries in the SOMA would imply an additional Treasury funding gap (see page 20 for a simplified illustration). Net issuance and funding gap ahead? Monthly net Treasury issuance, changes in Fed s holding of Treasuries and Fed s Treasury maturity profile, USDbn Overall, this should support Treasury yields. However, the particular curve dynamics will rely on the Treasury s issuance pattern going forward. If for example the Treasury s additional funding gap is issued mainly in T-Bills, the market reaction should be fairly muted, as these issues will likely be absorbed by the large (in terms of asset under management) US Government Money Market Funds. On the contrary, if the Treasury s additional funding gap is issued in Notes/Bonds, we could see a yield curve steepening pressure. However, the 30Y Treasury yield is already near the long-term neutral rate at 3.00% (according to the latest projections from the Federal Reserve) and quantitative tightening by means of a reduction in Fed s Treasury holding is to some extent already expected, as reflected by the consensus amongst analysts and primary dealers. Besides, a too excessive quantitative tightening could lead to temporary tightening of financial conditions, offsetting the steepening pressure, see slide 17. Hence, in our view, the potential steepening pressure induced by phased out or ceased reinvestments of maturing Treasuries relies heavily on the Treasury s issuance pattern going forward, but should be moderate compared to the taper tantrum in 2013. Source: Federal Reserve, US Department of Treasury, Danske Bank Markets Note: Herein Notes and Bonds includes FRN and TIPS. Primary dealer estimate of FY17-19 is based on (average) primary dealer feedback on 23, January 2017 reported in the Treasury Presentation to TBAC (see US Treasury). Here the frequency is converted from yearly to monthly. 13
Reducing Fed s holding of Treasuries - Additional considerations In contrast to a potential reduction of Fed s holding of MBS, phasing our or ceasing reinvestment of maturing Treasuries should not change the relative LCR demand versus supply of Treasuries. ON RRP facility floors overnight GCF Treasury repo rate Overnight GCF Treasury repo and ON RRP rate, bp Even though the overnight reverse repurchase agreement operations (ON RRP) facility is likely to remain unchanged for now (except the offering rate), a reduction of Fed s Treasury holding could induce a discussion: According to Fed staff, the ON RRP facility remains an important element of the operating regime with abundant supply of reserve balances and it could also be effective with an appreciable smaller balance sheet and supply of reserves. However, financial stability arguments suggest limiting the ON RRP facility as the facility might exacerbate disruptive flight-to-quality flows during a period of financial stress. As the ON RRP facility floors Treasury repo rates, limiting or removing the facility is likely to weigh on Treasury repo rates and hence seen in isolation add a widening pressure on Treasury ASW spreads. Source: Bloomberg, Federal Reserve, Danske Bank Markets 14
Risk of unwarranted financial tightening
Taper tantrum in 2013 Unexpectedly, Ben Bernanke hinted a QE quantitative easing tapering at his Congress hearing in May 2013, which led to an immediate sell-off in Treasuries, the socalled taper tantrum. Taper tantrum hit real yields and inflation expectations dropped in this period 5Y5Y marked based inflation expectations and 10Y yields, % As market based inflation expectations dropped, the higher Treasury yields were driven by a soar in real yields. However, over time, the tightening of monetary policy hit inflation expectations further and at the beginning of 2015, 10Y Treasury yields were back at the same level as before the taper tantrum. We do not expect quantitative tightening to impact markets to the same extent, as markets to some extent already have priced in a reduction. That said, too excessive quantitative tightening could lead to a tightening of financial conditions, offsetting the steepening pressure. Also, we think the Fed will postpone tightening monetary policy further if inflation expectations take another hit, as they are still subdued from an historical perspective. Source: Bloomberg 16
Unwarranted tightening of USD liquidity If the Federal Reserve attempts quantitative tightening of a too large magnitude, it could lead to an unwarranted tightening of USD liquidity, e.g. widen EURUSD CCS and FRA/OIS. Unwarranted tightening of USD liquidity is likely to widen FRA/OIS and EURUSD CCS 3m FRA/OIS and EURUSD 3m CCS, bp In particular, another hit to inflation expectations (both market based and survey based) could alter additional tightening, as they are already low to begin with. In this respect, the risk related to an excessive quantitative tightening is that it could lead to temporary tightening of financial conditions lowering Treasury yields, widen FRA/OIS spreads and Treasury ASW spreads. In the end, we do not expect the looming quantitative tightening to lead to an economic setback, as financial conditions are set to force the Federal Reserve to do the right thing no matter how far off course it may get initially. Source: Bloomberg, Danske Bank Markets 17
Appendix
Treasury roll-over in SOMA - Example from New York Federal Reserve See New York Federal Reserve: As a hypothetical example, if the SOMA had held USD1bn in Treasury note securities that matured on 15 December 2015, the maturing securities would have been exchanged for 3-year, 10-year and 30-year Treasury securities issued at auctions that settled on that same day. The USD1bn would have been allocated across these three securities in proportion to their announced offering amounts, as shown below : Value of Maturing Securities Security Announced Offer Size Poportional allocation SOMA Roll-over USD1bn 3-year USD24bn 41.4% USD0.414bn 10-year USD21bn 36.2% USD0.362bn 30-year USD13bn 22.4% USD0.224bn USD58bn 100.0% USD1bn Source: NY Fed 19
Example - A simplified illustration of the Treasury s potential additional funding gap in the case of ceased reinvestments of maturing Treasuries Net Marketable Borrowing: USD50bn Gross Issuance (excl. SOMA add-ons): USD400bn = - Maturing (excl. SOMA) USD350bn (+) Additional funding gap: USD30bn SOMA add-ons USD30bn Maturing in SOMA: USD30bn Note: The numbers used are only for illustrative purposes. 20
The Fed s operational framework Theoretically a two-tier floor system but a de facto corridor system Fed monetary policy rates, bp IOER FF spread drivers * Balance sheet cost * FDIC cost (deposit insurance cost) * Liquidity at banks vs at GSEs/Money Market Funds The Fed s pre-crisis operating model Create a small shortfall in the level of bank reserves. Need for O/N transactions. Push banks to bid up cash in the Fed funds market to cover the shortfall control liquidity injection with OMO. i.e. keep Fed funds rate within the policy target. Worked when bank reserves were under USD50bn. Banks were not getting paid on their balances at the Fed. New tools to control short-term money market rates Source: NY Fed, Bloomberg IOER: The rate that the Fed pays to banks for reserves held at the central bank. ON RRP: Similar to IOER, except the cash is lent to the Fed against Treasury collateral from the SOMA portfolio. In addition to banks, eligible counterparties include large money market funds and most of the GSEs. In theory, the ON RRP rate should be the lowest rate in the economy (riskless loan to the Fed collateralised with Treasuries). While the IOER and ON RRP are both floor rates, the Fed has created a de facto corridor system, as the effective Fed funds rate stays within the range between the two rates. 21
The Fed s key instrument - The ON RRP facility Since December 2015, the overall size of the ON RRP facility has been limited only by the value of Treasury securities held outright in the SOMA and each counterparty has a limit of USD30bn per day. The number of eligible counterparties for the ON RRP facility and the limit of USD30bn per counterparty implies an overall ON RRP facility size cap of approximately USD4,000bn, Hence, the effective cap for the ON RRP facility is the value of the Treasury securities held outright in the SOMA, i.e. USD2,445bn, as of 22 March 2017. Taking into account the Treasuries needed to conduct reverse repurchase agreements with foreign official and international accounts, Treasury securities needed to support the securities lending operations and required buffers, the Open Market Trading Desk anticipated around 2,000USDbn of Treasuries available for the ON RRP facility as of 16 December 2015 (see New York Federal Reserve). The offering rate is currently 0.75%, i.e. the spread between the IOER and the ON RRP is 25bp. At the November 2016 meeting, Fed Chair Janet Yellen reiterated that additional experience with the Federal Reserve s current monetary policy implementation framework would help inform policymakers future deliberation of issues related to a long-run framework and that decisions regarding these issues would not be required for some time. Furthermore, according to Fed staff, the ON RRP facility remains an important element of the operating regime with an abundant supply of reserve balances and it could also be effective with an appreciable smaller balance sheet and supply of reserves. Hence, the ON RRP facility is likely to remain unchanged for now (except the offering rate) with no cap on the overall size but caps on individual usage. However, financial stability arguments suggest limiting the ON RRP facility as the facility might exacerbate disruptive flightto-quality flows in a period of financial stress. 22
The US money market reform - Shift in investments, key elements The US money market reform (MMR) was adopted in July 2014 and came into effect on 14 October 2016. The key elements of the US MMR are the rules for floating net asset value (NAV) and the liquidity fees and redemption gates, i.e. as follows. NAV: The MMR introduces a floating NAV for sales and redemptions based on the current market value of the securities in the portfolio, instead of a stable USD1 share price. Hence, the risk of breaking the buck (NAV going below USD1) has, all else being equal, increased. Liquidity fees and redemption gates: The MMR provides new tools to money market funds to address a potential run on a fund. The new tools will give funds the ability to impose liquidity fees or to suspend redemptions. They will be enacted if a fund s level of weekly liquid assets falls below a certain threshold. Importantly, government money market funds are allowed to continue using the amortised cost method and are not subject to the new fees and gates provisions. For more details, see The US Money Market Reform: The Scandi Angle, 9 August. The outflow from prime money market funds into government money market funds accelerated ahead of 14 October 2016 Assets under management, USDtrn Source: Investment Company Institute Prime money market fund A money market fund that invests primarily in corporate debt securities. Government money market fund A money market fund that invests 99.5% (formerly 80%) or more of its total assets in cash, government securities and/or repurchase agreements that are collateralised solely by government securities or cash. Source: US Securities and Exchange Commission 23
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