Wary of bond 'cliff,' Fed plans cautious cuts to portfolio

By Reuters

May 07, 2015 06:16 AM EDT

The Federal Reserve is sketching out plans to prevent an abrupt contraction in its massive balance sheet next year, when some $500 billion in bonds expire and risk disrupting markets and the U.S. economic recovery.

Though it ended a stimulative asset-purchase program last October, the Fed is still buying mortgage and Treasury bonds to replenish its $4.5-trillion portfolio as holdings mature. The central bank has said it will keep reinvesting until some time after it begins raising interest rates later this year.

Asked publicly and privately about the longer-term strategy, Fed policymakers say they are in no rush to shrink the portfolio, suggesting they will seek to avoid a "cliff" - a disruptive end to reinvestments that might come if bonds are simply allowed to run off through maturity or prepayment.

Economic analysis shows that shifting the end of reinvestments by several months in either direction would have "essentially no effect on the economic outlook," San Francisco Fed President John Williams told reporters last Friday.

"My view is this would happen organically," he added. But to avoid confusing investors with too many changes at once, he said, the Fed should give investors time to get used to rate increases before allowing the balance sheet to shrink. "You want enough separation in time just so that, once we get the (rate) normalization process going ... then this would be a decision that would be of second-order."

Six years of crisis-era purchases meant to boost economic growth quintupled the size of the Fed's balance sheet. The Fed predicts it will take until 2020 to shrink the portfolio back to normal.

The central bank can always sell bonds, but it said in September it will rely primarily on run-off to reduce holdings in a "gradual and predictable manner."


St. Louis Fed President James Bullard told Reuters this year he wants to manage the rate of decline, a strategy that many bond investors expect. Simon Potter, the New York Fed official whose team manages the portfolio, said last month the central bank had an option to reduce the level of reinvestments gradually, rather than ending them all at once.

More than $200 billion of the Fed's Treasuries are set to expire in 2016, after very little matured this year. Among its mortgage-backed securities (MBS), which are harder to evaluate due to prepayments and amortizations, analysts estimate up to $300 billion could run off the balance sheet next year.

While some investors talk of a looming "balance sheet cliff," many Fed officials are more focused on when and how aggressively to raise interest rates, rather than on managing the reduction of holdings.

Simply allowing assets to roll off "is likely to be satisfactory," said Charles Evans, head of the Chicago Fed. "I think it's going to be at some point after we are comfortable in our liftoff strategy."

Cleveland Fed President Loretta Mester told reporters last week that "there's been no determination about what the appropriate timing would be."

According to a March survey by the New York Fed, primary dealers expect the portfolio to shrink about six months after the Fed hikes rates, or sometime in the first quarter of 2016.

But policymakers could delay that for fear of slowing the economy given consumer confidence remains fragile and some Americans still struggle to get loans. Before that, rate hikes could also be delayed if the state of the economy called for it.

Donald Kohn, a former Fed vice president, predicted in a note to Potomac Research clients that the Fed would keep reinvesting proceeds from maturing bonds until it hikes rates to 1 percent or more. That could be well into the second half of next year, according to the Fed's March forecasts.

Once the balance sheet starts to shrink, some analysts are predicting the Fed would keep reinvesting proceeds from half or even two-thirds of the roughly $40 billion in bonds expected to naturally run off each month, depending on the state of the economy.

"This means that the Fed will be a large and active participant in the bond market for the next few years," said Roberto Perli, a former Fed official who is now partner at research firm Cornerstone Macro.

Reliable demand from the central bank has helped bond markets stay near record highs, making it cheap for Americans to take on mortgages and other loans. A 30-year fixed-rate mortgage remains low at 3.9 percent, according to Bankrate.

The Fed is by far the top holder of agency mortgage bonds, with about a third of the market at $1.7 trillion, said Andrew Szczurowski, vice president and fund manager at Eaton Vance.

"The Fed has handcuffed itself and must be very careful when trying to exit the market," he said, "because the last thing it wants is for spreads to blow out on MBS and mortgage rates to rise substantially."

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