Published: Sun, April 09, 2017
Markets | By Lucia Cruz

Fed official: Bond holdings would be reduced gradually

It is now reinvesting the money it gets from maturing bonds, thereby keeping the size of its balance sheet unchanged. That contrasts with the surge in Treasury yields that occurred during the so-called "taper tantrum" of 2013, when then-Fed Chairman Ben Bernanke hinted the central bank would reduce its purchases of Treasuries and mortgage-backed securities that were created to bring down long-term interest rates.

Federal fiscal stimuli, analysts say, would cushion tighter financial conditions from interest rate increases and fewer bond purchases from the Fed. Those remittances are beginning to decline now that the central bank is lifting rates and, to help it do so smoothly, as it pays private banks an increasing rate of interest on their excess reserves.

The aim is to pull that off without jolting markets.

The New York Fed official had said in an interview last week that trimming the balance sheet was a substitute for rate hikes, which could prompt the Fed to "pause" raising rates at that time.

To the contrary, Fed officials said in documents this week and in prior statements that they want the US central bank's influence in the market to disappear as quietly as possible, and they promised a slow, predictable and well-telegraphed decline in the Fed's asset holdings.

On Wednesday, the Fed held $2.46 trillion in Treasuries and $1.77 trillion in MBS.

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But the Fed's asset holdings will not return to pre-crisis levels.

Investors have reacted to the Federal Reserve's plan to shrink the balance sheet so far in exactly the opposite way that policy makers had feared. If, as markets expect, the process starts in the middle of next year, the report estimated that point could be reached by the end of 2021.

This time around, New York Fed President William Dudley may have succeeded in convincing investors that the central bank would avoid any excessive financial tightening, according to Ben Emons, the Los-Angeles based chief economist and head of credit portfolio management at Intellectus Partners.

Moreover, the spread between yields on 10-year and 5-year U.S. Treasury notes widened as both yields fell, as investors bet short-term interest rates would be slower to rise than previously expected.

New York Fed President William Dudley, an advocate of low interest rates, said on Friday that shrinking the Fed's $4.5 trillion bond portfolio would prompt only a "little pause" in the Fed's rate hike plans, providing relief to dollar bulls banking on more than one rate increase this year.

At the January meeting of the Treasury Borrowing Advisory Committee, a panel that includes private investors and advises the agency on the best ways to fund its debts, members encouraged officials to get ahead of the curve and determine how their monthly sales of short- and long-term securities may have to change in response to the Fed's planned actions.

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