Joggers pass the Marriner S. Eccles Federal Reserve building in Washington, DC on Tuesday, August 18, 2020.
Erin Scott | Bloomberg | Getty Images
While the Federal Reserve may not raise its policy rate for years, there are growing expectations that it will soon adjust policies to address some of the recent turmoil in the bond market.
According to investors and economists who are closely monitoring recent moves and expect the central bank to address some of the biases it has encountered, the moves could be done as early as the upcoming March 16-17 meeting of the Federal Open Market Committee.
One possible move would be the third iteration of Operation Twist, a move the Fed last took almost a decade ago during the market turmoil at the time of the European debt crisis. Another could see a rise in the interest rate on reserves to solve problems in the money markets, while the Fed may also adjust the interest rate on overnight repo operations in the bond market.
The mechanics of Operation Twist is to sell shorter-term government bonds and buy roughly the same amount of dollars in longer-term securities. The aim is to boost short-term interest rates and lower those at the longer end, thereby flattening the yield curve.
The Fed ran the program in both 2011 and 1961. A market participant familiar with the Fed’s operations said central bank officials had contacted primary traders to assess the need for intervention.
“The perfect insurance recipe”
Longer-term bond yields have risen in the past two weeks to levels not seen since the Covid-19 pandemic. While staying low historically, markets have been concerned about the pace of the advance. The bond market was clam on Monday with rates mostly lower around the middle of the curve.
Implementing the system could help ease some of the nerve-wracking nerves that came with a recent 5-year rate hike on the curve. The “twist” is an indication to adjust the length of their purchases to match the longer end, and the buying and selling of equal weights means that the Fed’s already bloated $ 7.5 trillion balance sheet will not be added any further.
“The Fed is simultaneously losing control of the US front-end and back-end yield curves for various reasons,” said Mark Cabana, interest rate strategist at Bank of America Global Research, in a statement to clients. “Twist, a simultaneous sale of US front-end Treasuries and purchase of longer-term government bonds [bonds]from our point of view is the perfect political recipe for the Fed. “
Cabana said the train “kills three birds with one stone”. Namely, it increases the interest rates at the short end of the duration spectrum, ensures stability in the backend and does not expand the balance sheet and therefore requires banks to hold more capital.
“We believe that no other Fed accounting option can address each of these issues so effectively,” he wrote. “To be clear, the Fed is going to be turning to solve market function problems, not economic problems.”
Indeed, the Fed welcomes some upward pressure on yields as this reflects a growing economy and rising inflation expectations towards the central bank’s 2% target.
However, the trend poses some problems for the Fed, which a weak 7-year banknote auction showed last week. The Fed needs bond auctions to do well as a spike in supply is on the way from a federal government that expects to run a deficit of at least $ 2.3 trillion this year.
In times of inflation, investors tend to shy away from longer-term bonds because their interest rates cannot keep up and bondholders lose capital. For this reason, Cabana expects the Fed to sell $ 80 billion a month in Treasury bills, buying bonds with a maturity of more than four and a half years.
FOMC members discussed at their November meeting market expectations that the central bank would begin to extend the average duration of its purchases. Members advocated “ongoing careful scrutiny” of the composition of their bond holdings.
“Participants noted that the committee could, if necessary, provide more accommodation by increasing the pace of shopping or by shifting its purchases from the Treasury to longer-term ones without increasing the size of its purchases,” said the minutes of the meeting.
Increase in interest rates for reserves and repos
There are other problems in the market, and so the Fed’s actions may not be limited to Operation Twist.
Another step could be to increase the interest rate on excess reserves from 0.1% to 0.15%. Although there are essentially no excess reserves at the moment, as the Fed cut the minimum during the Covid-19 crisis, the IOER serves as a guardrail for some short-term interest rates, which is important for money market funds that have had to buy negative bills for real prices.
“Essentially, the Fed needs to create raised floors in the US economy to keep things going that need positive returns,” said Fed veteran Christopher Whalen, head of Whalen Global Advisory.
While saying he understood the IOER move, Whalen said he was skeptical of how successful the Fed will be in implementing Twist.
“No matter how well-intentioned you are, your efforts to construct things are slowly weakening the system,” he said. “You have another bad auction or two and we’re done.”
Still, Cabana expects the Fed to signal the additional steps this week. Chairman Jerome Powell speaks during an event on the Wall Street Journal Thursday, and a number of other Fed officials are also in attendance to share their views this week.
Markets worried about how things are likely to go will welcome the Fed’s move, said Joseph Brusuelas, chief economist at RSM.
In addition to implementing and adjusting Twist for IOER, Brusuelas expects the Fed to also raise the interest rate on repo operations from zero to five basis points overnight.
While Brusuelas said markets were expecting interest rates to rise this year, “what we didn’t expect was an overreaction to the domestic reflation in the bond market. This has clearly caught the Fed’s attention.”
“The market would welcome the lifting of the IOER as well as any announcement to turn the curve downward to keep the economy on track,” he added.