The Federal Reserve’s changing strategy….. Harold AGJ Davis, Winnipeg,

There is increasing nervousness about the end game for the Federal Reserve’s ultra-accommodative monetary policy. The speed of both interest rate rises and the unwinding of quantitative easing are closely watched topics. Yet some observers may not realise that substantial shifts have already begun because they have been obscured by “headline numbers” that remain unchanged.

Looking back, U.S. Treasury securities of all maturities held by the Federal Reserve as assets rose in three stages from about $500 billion in 2008 to $2,465 billion in 2014 where they have remained ever since. On the surface, other than a little rate tinkering, little has changed for three years. However, this ignores the evolving term structure or maturity profile of the Federal Reserve’s holdings which has been getting shorter since 2015.

During 2013 and 2014, the Fed held no U.S. Treasury securities maturing between 91 days to 1 year, none. Starting in 2015, the Fed began to acquire T-bills and other short dated Treasury securities and now holds $322 billion worth.

Given that the total of all maturities remains unchanged, this shift means that the Federal Reserve has trimmed its bond holdings in favour of adding a good and rapidly rising money market position. Now, like any investor holding cash or near-cash, the Fed has new open market flexibility.

Aside from the obvious implication that the Federal Reserve has started an orderly retreat from continuously supporting the bond market and suppressing long term interest rates which could be construed as generally bearish for fixed income markets, the new cash position might also be used by the Fed to step into the bond market on the buy side, if needed, to prevent any aggressive selloff from turning into a meltdown.

Given $19.85 trillion in US federal debt, a 2017 budget deficit expected around $665 billion, a Congressional Budget Office estimate for another deficit of $593 billion in 2018 to be followed by more red ink for years to come, the stakes are high. Moreover, a loss of market control could cause future budget deficits to balloon rapidly in response to higher interest expenses.

The Federal Reserve’s changing strategy….. Harold AGJ Davis, Winnipeg,

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