Fed s quantitative tightening details Impact on the balance sheet and reinvestments Mathias Røn Mogensen Analyst, Fixed Income Research +45 45 13 71 79 mmog@danskebank.dk 19 June 2017 Investment Research www.danskebank.com/ci Important disclosures and certifications are contained from page 9 of this report
Quantitative tightening details Summary In the presentation Fed s Quantitative Tightening : Fixed Income Implications, 6 April 2017, we analysed the potential fixed income implications from Fed s imminent quantitative tightening. In this add-on, we quantify the effects on Fed s balance sheet and reinvestments from the anticipated cap-structure on reinvestments (see FOMC issues addendum to the Policy Normalization Principles and Plans, 14 June 2017). In the addendum it was stated that the Fed anticipates to decrease reinvestments of the principal payments received from securities held in SOMA by gradually increasing caps on the dollar amounts of bonds that will be allowed to run off each month and only reinvest the amounts that exceeded the caps each month. In particular: For Treasuries, the Fed anticipates that the cap will be set at USD6bn/month initially and increase in steps of USD6bn at three-month intervals over 12 months until it reaches USD30bn/month. For agency debt and MBS (Fed only holds a very limited amount of agency debt), the Fed anticipates that the cap will be set at USD4bn/month initially and will increase in steps of USD4bn at three-month intervals over 12 months until it reaches USD20bn/month. We still do not expect quantitative tightening to have a major impact on Treasury yields like the taper tantrum in 2013. Fed will still have a significant reinvestment need in 2018, but there is a risk that quantitative tightening could lead to an unwarranted tightening of financial conditions. As we wrote in Research US: Fed s regulatory hurdle for starting quantitative tightening, 13 March 2017, 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. Hence, a total maximum cap of USD50bn/month reached after 12 months of a balance sheet reduction could impose a risk of an unwarranted tightening of USD liquidity. That said, in the addendum a more cautious stance regarding the level of the quantity of reserve balances was also mentioned as it will reflect the banking system's demand for reserve balances and the Committee's decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalisation. 1
Jan Feb 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 cap-structure The Treasury (Notes, Bonds, FRN and TIPS) holding in SOMA currently constitutes around USD2,445bn. It remains a question whether the Fed will change its current Treasury reinvestment strategy, thereby obtaining a smoother balance sheet reduction. As shown in the RHS chart, the anticipated monthly caps are nonbinding in some months, meaning that a smaller amount of Treasuries than the caps suggest would run off in some months if the current Treasury maturity outlook remains unchanged. 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 8. Treasury cap-structure would be non-binding with the current maturity outlook for 2018 and 2019 Par value of maturing Notes, Bonds, FRN, TIPS and capstructure, USDbn 80 70 60 50 40 30 20 10 0 Par Value (USD bn) 2018 2019 Maturity FRN Notes and Bonds TIPS Cap Importantly, since 2012 SOMA has not participated in T- bill auctions as part of the Maturity Extension Program (MEP), i.e. Treasury rollovers in SOMA are currently conducted in Treasuries with maturities beyond 2 years. Note: Here it is assumed that quantitative tightening begins in Q1 2018 Source: Federal Reserve, Danske Bank Markets, 7 June 2017 data 2
Fed s Treasury holding - Cap-structure, balance sheet reduction and reinvestments Assuming that quantitative tightening begins in Q1 2018 and that the maturity profile on slide 2 remains constant: Treasury rollovers in SOMA remain unchanged and the SOMA USD104bn Treasuries maturing in 2017 are not reinvested in Treasuries maturing in 2019. Then the anticipated cap-structure implies a de facto balance sheet reduction (solely by means of Treasuries) of USD174bn in 2018 and USD255bn in 2019, i.e. around USD430bn by the end of 2019 (see the light blue line in the RHS chart). As seen from slide 2, the anticipated Treasury capstructure is non-binding. The maximum capacity of the structure would otherwise imply a balance sheet reduction of USD180bn in 2018 and USD360bn in 2019, i.e. USD540bn by the end of 2019 (see the grey line in the RHS chart). In addition, the Fed will still be a fairly active buyer of Treasuries reinvesting USD252bn and USD110bn in Treasuries during 2018 and 2019 (see the red line in the RHS chart). If the full Treasury cap were to run off, the reinvestments in Treasuries would be around USD245bn and USD5bn in 2018 and 2019. In comparison, SOMA redemptions and reinvestments were/are only around USD4bn (mainly due to MEP), USD216bn and USD194bn in 2015, 2016 and 2017. Balance sheet reduction from Treasury cap-structure Treasury: SOMA redemptions, SOMA reinvestments, capstructure and balance sheet reduction, USDbn 900 800 700 600 500 400 300 200 100 USDbn 0 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 Apr-19 Jul-19 Oct-19 Jan-20 SOMA Treasury redemptions Treasury cap SOMA Treasury reinvestments Balance sheet reduction Note: The calculations are conducted under the assumptions mentioned on this slide, i.e.: - quantitative tightening begins in Q1 2018 - SOMA Treasury maturity profile remains unchanged for 2018 and 2019 (see slide 2) Source: Federal Reserve, Danske Bank Markets, 7 June 2017 data 3
Fed s MBS holding - The build-up, maintenance and balance sheet reduction The MBS holding in SOMA currently constitutes around USD1,770bn. According to the New York Federal Reserve only fixed-rate 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. Development in Fed s MBS holding and MBS cap-structure Monthly change in MBS holding, estimated prepayments and MBS cap-structure, USDbn 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. Over the first year, the MBS cap-structure summarizes to USD120bn. Hence, the Fed is likely to remain a fairly active buyer of MBSs during 2018. Assuming that the prepayments and scheduled repayments of principals exceeds the monthly caps in both 2018 and 2019, although they are likely to be less in some months, implies a balance sheet reduction of USD360bn by the end of 2019. Source: Federal Reserve, Danske Bank Markets Note: The reported CPR estimate is based on Bloomberg s Prepayment Model 4
Decomposing the liability side of Fed s balance sheet - Reducing supply of liquidity Note: *The estimated balance sheet is based on the assumptions mentioned on slide 2. Besides, the MBS cap-structure is assumed to be binding. **The balance sheet with binding cap-structure assumes that quantitative tightening begins in Q1 2018. ***NY Fed Primary Dealer Survey results as of May 2017. In the NY Fed Primary Dealer Survey, participants were asked: Please indicate the percent chance that you attach to the following possible outcomes for the par value of the SOMA portfolio at the end of 2019, conditional on not moving to the ZLB at any point between now and the end of 2019. We have translated these possible outcomes into future balance sheet sizes by assuming that the balance sheet components excl. SOMA remain constant. Note that the assigned probabilities do not add up to 100% as we have excluded the probabilities assigned to the area above(2%)/below(8%) the ones presented in the chart. Source: Federal Reserve, NY Fed Primary Dealer Survey, Danske Bank Markets As we wrote in Research US: Fed s regulatory hurdle for starting quantitative tightening, 13 March 2017, 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. Although it is to some extent already expected, as indicated by the Primary Dealers assigned probabilities to the future balance sheet size, a balance sheet reduction of Fed s anticipated magnitude could impose a risk of an unwarranted tightening of USD liquidity - particularly in connection with a rebuilt of the US treasury cash buffer at Fed (see slide 7). That said, in the addendum a more cautious stance regarding the level of the quantity of reserve balances was also mentioned as it will reflect the banking system's demand for reserve balances and the Committee's decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization. 5
Appendix
US Treasury cash buffer at Fed - Autonomous factor on Fed s balance sheet In 2014, the US Treasury started looking into the option of building a cash buffer. In May 2015, it officially changed its cash balance policy, so that it will now hold a level of cash generally sufficient to cover one week of outflows in the Treasury General Account, subject to a minimum balance of roughly USD150bn. Hence, the US Treasury prefers a cash buffer in the area USD150bn- USD500bn. US Treasury cash buffer held at Fed set to be rebuilt longterm and hence tighten USD liquidity US Treasury cash buffer, USDbn The suspension of the US debt limit expired 15 March 2017. In a recent update from the Congressional Budget Office (CBO), it estimates the Treasury would have sufficient cash by using extraordinary measures to meet its usual payments without lifting the debt limit until sometime in the fall of this year (see pdf file here). We do not expect a major impact on the US growth outlook in the short run from higher fiscal uncertainty but risks increase the longer it takes to reach a deal. The US Treasury s cash buffer at the Fed has declined but is set to be rebuilt when a solution is found leading to a tightening of USD liquidity. Source: Federal Reserve and US Treasury forecast from 1 May 2017 7
Treasury rollover 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 8
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