The impact of unconventional monetary policy on Treasury markets

In the years since the onset of the global financial crisis, the Federal Reserve (Fed) has embarked on several rounds of unconventional monetary policy, growing its balance sheet all along the way. Now that these policies arguably have ended, the Fed has indicated its next move will be to raise rates. In the wake of all this, we think one particular idiosyncrasy of the Fed’s large balance sheet could have ramifications for the U.S. Treasury market.

First, some background

The Federal Reserve began its quantitative-easing policy (known as QE, for short) in December 2008. The program involved large purchases of agency mortgage-backed securities (MBS) as well as agency debt. The purchases were expanded in March 2009 to include $300 billion in U.S. Treasury securities, in addition to including more MBS and agency purchases.

As originally conceived, the goal of QE was twofold: (1) to lower borrowing costs and thereby support the housing market, and (2) to lower long-term interest rates in order to help support the economic recovery and stabilize inflation expectations. When the economy did not evolve as hoped, the Fed felt the need to do more.

In November 2010, the Fed announced the purchase of an additional $600 billion in Treasurys (the program was accordingly referred to as QE2). And there would be more: In September 2011, Fed officials implemented a so-called "Operation Twist," which entailed selling $400 billion of Treasury notes with maturities of less than 3 years from its System Open Market Account (SOMA) portfolio and simultaneously purchasing notes with maturities between 6 and 30 years. In June 2012, Operation Twist was extended by an additional $267 billion. The operation concluded in December 2012, before the implementation of another round of easing (QE3).

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Growth of the Fed’s overall securities portfolio and growth of Treasury holdings in the Fed’s portfolio

Chart 1a and 1b

Taken together, QE1, QE2, QE3, and Operation Twist greatly affected the Fed’s SOMA portfolio, bringing its Treasury positions to approximately $2.4 trillion and the total SOMA portfolio to approximately $4.2 trillion. Prior to this unconventional policy, the size of the Fed’s portfolio was dramatically smaller, ranging between $500 billion and $800 billion (see Charts 1a and 1b).

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Chart 1a. Growth of the Fed’s overall securities portfolio

Source: Bloomberg.

Chart 1b. Growth of Treasury holdings in the Fed’s portfolio

Source: Bloomberg.

Charts are for illustrative purposes only.

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Maturity profile of SOMA holdings

Chart 2. Maturity profile of SOMA holdings

Possible fallout

The results of QE and Operation Twist raised a question the Fed would have to answer: As the bonds it had purchased reached maturity, what would it do with the proceeds? The Fed’s answer was to reinvest its maturing Treasurys at auction (so long as the amount maturing on any given day was greater than $2 million). As a result of the extension of its portfolio invoked by Operation Twist, the amount of securities eligible for reinvestment has been relatively small thus far — for the entire calendar year 2015, for instance, there will be approximately $3.5 billion in Treasury securities maturing. In 2016, however, that amount will swell to approximately $215 billion, as seen in Chart 2.

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Chart 2. Maturity profile of SOMA holdings (Treasury notes, bonds, and TIPS*)

Source: Federal Reserve Bank of New York.

*Treasury inflation-protected securities

How a reinvestment program can become inflammatory

On Aug. 15, 2015, approximately $1.3 billion in Treasury notes in the Fed’s portfolio matured, providing a good picture of how the reinvestment program works. Consider that on Aug. 11, 12, and 13, the U.S. Treasury auctioned off $24 billion in 3-year notes, $24 billion in 10-year notes, and $16 billion in 30-year bonds.

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Maturity profile of SOMA holdings for 2016

Chart 3. Maturity profile of SOMA holdings for 2016

The final results of the auction show that the Fed purchased approximately $482 million from the 3-year auctions, another $482 million from the 10-year auctions, and $322 million from the 30-year auction. Those amounts added up to the precise amount that had matured from the Fed’s portfolio in August. (How the Fed arrives at the amount of each issue to purchase is simple; it is just a ratio of the size of each issue to the total size of the auction.)

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Potential 2016 twist by maturity

Chart 4. Potential 2016 twist by maturity

With evidence of the reinvestments in hand, we can begin painting a picture of how they could affect Treasury markets in the coming quarters. We start by recognizing that the amount of Treasurys that mature each month is not uniform. Looking out into 2016, for instance, we see that approximately 60% of the maturing bonds have maturity dates between February and May (Chart 3). If we assume the composition of the Treasury auctions in 2016 will be much the same as 2015, we can estimate the breakdown of the purchases by maturity. Such an analysis suggests that the intermediate part of the Treasury curve will benefit the most, as shown in Chart 4.

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Chart 3. Maturity profile of SOMA holdings for 2016 (Treasury notes, bonds, and TIPS)

Source: Federal Reserve Bank of New York.

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Chart 4. Potential 2016 twist by maturity

Source: Federal Reserve Bank of New York.

Charts are for illustrative purposes only.

An uncommitted Fed feeds uncertainty

The Fed has stated that it will continue reinvesting the proceeds from its maturing Treasurys until "sometime after" it begins to raise the federal funds rate (the rate that banks charge each other for overnight loans to help meet their reserve requirements at the Federal Reserve). We got a glimpse of what "sometime after" may mean on June 5, 2015, when William Dudley, the president of the Federal Reserve Bank of New York, told reporters that he would like to get short-term rates to a "reasonable level” before ending reinvestments. He then somewhat clarified his view of what a reasonable level would be: "How far that is, you know, if it’s 1%, or 1.5%, I haven’t really reached any definitive conclusion (Source: Bloomberg News)."

More noncommittal language followed at a June 17 press conference in which Fed Chairwoman Janet Yellen was asked about the timing of the conclusion of the reinvestment program. In her reply, she said that it "would depend on economic and financial conditions, and [we have] not made any further decisions." She went on to say, "I can’t provide any further detail. It’s obviously something we will be thinking about (Source: Bloomberg News)."

Absent a clear timeline from Fed officials, the market is forecasting the federal funds rate hitting 1% in April 2017 and 1.5% in 2018. Assuming the Fed maintains its current policy stance, we believe it is about to extend its reinvestment program in what we might refer to as a stealth Operation Twist, with total reinvestments between $270 billion and $780 billion.

Open questions and possible implications

Given the sheer magnitude of this reinvestment activity, we anticipate the Fed will provide further guidance late in the coming months. But if the guidance is unspecific, and if current policy remains unchanged, we think there will be a sizable amount of stealth Operation Twist taking place during the next couple of years. Among the implications we are keeping in mind as we make decisions for the portfolios we oversee:

  • The size of future Treasury issuance will be affected. The Fed’s reinvestments will be added to the auctions, thereby increasing the amount of each issue. This will result in the Treasury needing to issue less debt than it has anticipated.
  • The yield curve will be influenced as the Treasury takes steps to offset the effects of the bigger auctions. Will they be forced to reduce the amounts auctioned to the public? If so, this should be supportive for Treasurys, specifically along the yield curve where the purported reductions happen.
  • The Fed will further complicate the eventual exit of its large balance sheet. By re-extending its portfolio of Treasurys, the Fed will only delay the need to address its large balance sheet.

Aside from the possible ramifications for securities markets, any extended period of reinvestments raises another — if more obscure — issue. The Fed’s own website warns that it is prohibited from buying Treasurys directly from the U.S. Treasury; instead, it must pursue purchases in the open market (Source: U.S. Federal Reserve). This procedural item might seem minor, but we believe it’s one more notable facet of what has become an increasingly intriguing story.

All in all, we think it will be fascinating to see how the Fed navigates the consequences of its prolonged QE policy.


The views expressed represent the Manager's assessment of the market environment as of December 2015 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Interest payments on inflation-indexed debt securities will vary as the principal and/or interest is adjusted for inflation.

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