July 20, 2017 / 1:45 PM / a year ago

COLUMN-Fed's bond market footprint smaller even after QE: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

* Fed's bond holdings: bit.ly/2uLAne8

* Fed's bond holdings: tmsnrt.rs/2ubltuK

By Jamie McGeever

LONDON, July 20 (Reuters) - That the Federal Reserve is about to reduce its footprint in the U.S. bond market will surprise no one. What may surprise many is this: that footprint is smaller today than it was before the global financial crisis.

It begs a question about why the Fed feels compelled to shrink its balance sheet at all. Or at least why it would even consider any outright selling of the securities on its book.

The U.S. central bank owns $2.46 trillion of Treasuries, more than three times the amount it held in 2007 just before the global banking system froze and brought the world economy to its knees, and around five times more than it did in 2000.

That’s 23.1 percent of all outstanding Treasury notes and bonds. But in 2007, the Fed’s market share was 24.7 percent and in 2000 it was 23.6 percent. It was as high as 29 percent in 2002.

The relatively high proportion of Fed holdings in 2000-2007 — between 23.6 percent and 29 percent — was mainly because the U.S. government budget deficits in most of those years were much smaller.

Indeed, the budget was in rare surplus in 2000 and 2001. A major concern at the time was the lack of new debt supply, and the Treasury discontinued the long bond in 2001.

Still, it’s remarkable that after buying $1.7 trillion of Treasuries, the Fed’s market share today is smaller than it was pre-crisis.

Its bond market presence was indeed beefed up post-2008 as it sought to kill the threat of deflation and give the kiss of life to the U.S. economy and financial system. In 2008-2010 its Treasuries holdings represented 14.2-15.9 percent of all notes and bonds, rising to 25.1 percent in 2014.

The Fed’s journey in the mortgage-backed securities market was even more dramatic. It now holds some 25-30 percent of outstanding MBS debt, compared with zero pre-crisis. Investors may be paying closer attention to how the Fed winds down its MBS holdings than Treasuries.

Even if the Fed keeps its stockpile of Treasuries steady at $2.46 trillion, its bond market footprint will naturally shrink as issuance rises. According to Wells Fargo, net bond issuance in 2018 alone, comprising all interest-bearing securities, will rise to just under $800 billion.


The Fed has raised interest rates four times even though inflation has now undershot its 2 percent target for 62 consecutive months. It is set to hike further and has committed to shrinking its balance sheet.

In doing so it is unwinding not only post-crisis emergency measures but also its historical bond market presence at a vulnerable point in the interest rate cycle.

Fed chair Janet Yellen said last week that the Fed plans to start reducing its overall Treasuries holdings later this year by reinvesting only a portion of the holdings that mature each month, marking the final exit from crisis-related policies.

Yet she and other central bankers remain scarred by the global crisis and are doing everything in their power to ensure broader market and financial stability.

Yellen and her counterparts in Europe have recently signaled their preference to normalise policy. But they have found themselves talking yields back down only days later, a reflection of how much they fear a deeper and more prolonged bond market selloff.

The big unknown for Yellen, her Fed colleagues and financial market participants the world over is at what price will buyers lend to the government when the Fed begins its gradual withdrawal.

It is hoped that private sector demand from pension and insurance funds, and overseas buyers like central banks and sovereign wealth funds, ensure that the gradual winding down of Fed holdings is less disruptive than some fear.

But investor sentiment towards fixed income in general is poor. Sovereign bonds are considered to be very expensive - both on a historical basis and relative to other assets like equities - and the returns on offer are low.

The Fed’s hope is that historically committed buyers of Treasuries remain committed buyers as it steps back.

Reporting by Jamie McGeever; Graphics by Ritvik Carvalho Editing by Jeremy Gaunt

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