Much has been made of the Federal Reserve’s promises to “normalize” its balance sheet in an attempt to reverse the effects of its quantitative easing (QE) program. QE involved the Fed purchasing an unusually large proportion of Treasury bond and note issuance in an attempt to reduce interest rates and increase asset prices. This unprecedented intervention in government debt markets, taken after the crisis of 2008, has always been viewed with uneasiness in financial circles since it raises some uncomfortable questions about the nature of government debt and the central bank’s relationship to it. For example, one might reasonably ask if the Fed can create bank reserves out of thin air to purchase Treasury debt why the federal government borrows money in the financial markets at all.
To fend off unorthodox ideas like this, the Fed has always referred to QE as a temporary measure taken in an emergency. As a result, the impetus towards ending and even reversing the bond purchases has been strong. This push never came to anything more than fine sentiments under Janet Yellen, but the new Fed chairman, Jerome Powell, has displayed a willingness to “normalize” the central bank’s holdings of Treasury debt.
Contrary to what many people believe, the Fed has customarily owned a sizable portfolio (roughly 10-15%) of outstanding Treasury securities—purchased in the usual manner (i.e., with bank reserves created ex nihilo). Some of these Treasuries are used in the Fed’s open market operations whereby it sets short-term interest rates. However, during QE, the Fed shifted its holdings to longer-term Treasuries and by 2014 owned almost half of the outstanding issuance of greater than ten years maturity.
We had previously noted that the Fed could reduce its holdings to its long-term percentage simply by letting its portfolio move towards maturity while not purchasing any new issuance. And while the Fed has continued to buy 5-10% of each new issue of 30 year Treasury debt, you can see from the above chart that it should be back to its historical norm in a few years. At the same time, fears that the Fed would begin selling some of its long-term portfolio have been a false alarm—in the last year the Fed has only sold $190 million 30-year bonds (mainly, one supposes, as a trial to see how the process would work.
But while the Fed has been cutting back on its holdings of long-term debt simply by standing pat, the Treasury has not been idle. Thanks to rising deficits, the 30-year annual issuance has been increased from $168 billion to $178 billion, and non-Fed holdings of Treasury 30-year bonds now exceed $1 trillion (a more than five-fold increase since 2008.)
One can easily envision the Fed re-engaging in QE a few years down the road as the budget deficit continues its seemingly inexorable rise.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Doylestown Wealth Management, Inc. are separate entities from LPL Financial.