Don’t fear the taper: Fed to dominate treasury market for years

By Liz Capo McCormick and Rich Miller


Treasury investors fretting about when the Federal Reserve will scale back its bond purchases may be missing the bigger picture: Its more than $5 trillion stockpile will make it a major force for years to come.

The prospect of a pullback in buying edged a little nearer Wednesday when minutes of the Federal Open Market Committee’s April meeting showed that a number of officials were willing to discuss it if the economy keeps improving. Yields rose on the news.

But bond bulls say the Fed’s virtually inextricable presence in the world’s largest bond market means it will provide crucial support long after any price blips come and go when it brings the buying spree to a close.

The central bank’s Treasury holdings have doubled since March 2020, accounting for nearly one-quarter of the total outstanding, a bigger share than it held even after the 2008 credit crisis. It’s a result of aggressive moves to keep the market functioning and hold down rates on everything from mortgages and car loans to corporate and municipal bonds.

“The Fed will have a big hand in fixed-income markets for as far as the eye can see,” said Matt Nest, portfolio manager and global head of active fixed income for State Street Global Advisors.

The stake is so large that even once the Fed’s purchases wind down, it is expected to keep its holdings steady by buying new Treasuries whenever old ones mature, reducing the amount that would need to be sold to the public. That’s given some investors confidence that rates won’t rise too quickly — or by too much — even as yields head back toward the approximately 14-month high hit in March amid fears the economy is at risk of overheating.

“The Fed is definitely not going anywhere anytime soon with regard to the Treasury market,” said Mike Pugliese, an economist at Wells Fargo Securities, which predicts the Fed will begin tapering its purchases in January 2022 and end them around November.

But he expects the central bank to keep its stake steady through the next four years. “The Fed is going to comfortably hold between 20% to 25% of the Treasury market, remaining the largest holder of Treasuries, until about 2025,” he said.

That backdrop, combined with the prospect the government’s debt managers will cut note and bond auctions later this year as the economy rebounds, is helping to keep yields low despite the sharp pickup in growth and rising consumer prices. The Treasury’s net private borrowing of notes and bonds will fall next year to $1.99 trillion, from $2.75 trillion this year, according to JPMorgan Chase & Co.

The central bank’s holdings of Treasuries have been growing by $80 billion a month, and it’s also adding $40 billion in mortgage debt to its balance sheet. That’s left it on course to buy a total of $960 billion of Treasury notes and bonds in the secondary market this year after snapping up $2.18 trillion last year. Strategists at JPMorgan predict the Fed will buy $390 billion more in 2022 before wrapping up its purchases.

The minutes of the FOMC meeting reported that “a number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”

The prospect of a such a slowdown has sown some consternation. The 10-year Treasury yield rose to the day’s high after the minutes, reaching 1.69% as traders boosted bets on the outlook for Fed rate hikes. Those gains weren’t sustained and the yield has fallen about 2 basis points to 1.65% Thursday.

The benchmark yield is just a little more than half the average of the past two decades, and some analysts are confident that Fed Chair Jerome Powell and his colleagues will take a cautious approach to winding down quantitative easing.

“The Powell Fed is skittish about touching any aspect of its balance sheet, which is why it’ll be slow to slow asset purchases and will never sell securities outright on the back end of QE,” said former Fed official and Mellon chief economist Vincent Reinhart.

Peter Yi, head of taxable credit research at Northern Trust Asset Management, thinks there’s limited upside to long-term Treasury yields. He expects the 10-year yield to swing between 1.25% and 1.75% through the rest of 2021 and has been buying when yields back up. Percolating inflation, with U.S. consumer prices climbing in April by the most since 2009, will prove temporary, he added.

“The Fed has tools in their toolkit that they are going to use if they absolutely need to do it to prevent 10-year yields from jumping dramatically and in a disorderly way,” Yi said.

The last time the Fed began to pull back from asset purchases was from January through October 2014, when it unwound the quantitative easing measures ushered in after the 2008 credit crisis. While Treasury yields rose in 2013 in anticipation of that, the effects were muted, with yields falling in 2014.

The Fed was in no rush to unload its bond holdings, however, and kept rolling them into new securities when they matured. In October 2017, the bank began to whittle down its portfolio, only to stop abruptly in September 2019 when it caused mayhem in the overnight lending market.

Dan Krieter, a strategist in BMO Capital Markets’ fixed-income strategy group, doesn’t see the Fed shrinking its balance sheet for years.

“It’s becoming harder and harder for the Fed to ever extricate itself from the financial system,” Krieter said. “At least for the next five or so years, the Fed isn’t even going to hint at the idea of reducing its balance sheet.”