And so it begins...Fed Discusses Limited Bond Sales to Withdraw Stimulus

Discussion in 'Financial Futures' started by Cdntrader, Jan 1, 2010.

  1. Fed Discusses Limited Bond Sales to Withdraw Stimulus (Update1)
    Share Business ExchangeTwitterFacebook| Email | Print | A A A
    By Craig Torres

    Dec. 31 (Bloomberg) -- Federal Reserve officials are considering a proposal to schedule limited sales of bonds from the central bank’s $2.2 trillion balance sheet as part of a range of tools for withdrawing record monetary stimulus.

    The Federal Open Market Committee discussed asset sales at its November meeting, with some members in favor and others warning that it would cause “sharp increases” in longer-term interest rates, according to minutes of the meeting released Nov. 24. A middle route now being studied would allow small amounts of bonds to be unloaded at announced times.

    “The attitude toward asset sales is changing in terms of more in favor and more open minded, and doing it very gradually,” said former Fed Governor Laurence Meyer, vice chairman of Macroeconomic Advisers LLC in Washington. Devising a plan for pulling back stimulus “is under way intensively on the Federal Open Market Committee,” he said.

    Chairman Ben S. Bernanke is trying to wind down emergency stimulus programs that helped avert a second Great Depression, while alleviating concerns that inflation will accelerate as the economy picks up. U.S. Treasury securities posted their worst performance since the 1970s after the Obama administration borrowed record sums to help drive the rebound from recession. Yields on 10-year notes are close to their highest level since June, rising to 3.84 percent at 4:45 p.m. in New York.

    Loss of Control

    Without first reducing or locking up the $1 trillion Bernanke pumped into financial markets, policy makers may raise their target for the benchmark interest rate only to watch it trade below that level. The Fed cut the main rate, the federal funds rate, to between zero and 0.25 percent in December 2008 and kept it there at the last FOMC gathering on Dec. 15-16.

    “Here is the worry: What if they try to tighten and they lose control of the federal funds rate?” said Mark Spindel, chief investment officer of Potomac River Capital LLC in Washington, which specializes in inflation-linked bonds. “The challenge they have is to articulate how they are going to tighten and make sure all these tools work together.”

    The Fed has expanded reserves through emergency programs purchasing $1.7 trillion in bonds. As of Dec. 30, the central bank held $776.5 billion of U.S. Treasury securities, $160 billion of bonds issued by federal agencies and $908 billion of agency mortgage bonds guaranteed by companies such as Fannie Mae and Freddie Mac.

    Best Performance

    Mortgage-backed securities returned 4.8 percentage points more than Treasuries this year, their best performance in at least 20 years, according to Barclays Capital index data. The Fed’s program to buy $1.25 trillion of the securities ends as soon as March.

    The Fed is developing tools that can help take reserves off the market. This week, the Fed proposed selling term deposits to banks, which would remove reserves from the day-to-day trading market, locking them up for as long as six months.

    The New York Fed began this month testing reverse repurchase agreements as another way to pull cash out of banks. In a reverse repo, the Fed contracts to sell and repurchase securities over a set period, draining cash from the banking system.

    By making small, publicly announced sales of bonds, the central bank would permanently drain excess reserves while limiting investor concerns about an increase in the supply of such securities, economists said.

    Hit Target

    The federal funds market underscores how the Fed may need to use several tools to hit its interest-rate target. While the Fed promises to pay banks 0.25 percent to keep excess funds on deposit at the central bank, the so-called effective rate, or market rate, has averaged 0.12 basis points this month.

    Fannie Mae and other government-sponsored enterprises that are ineligible to deposit money at the Fed “have pulled down” the fed funds rate by selling funds in the market, New York Fed researchers said in a paper this month.

    Fed officials must be cautious in how they manage reserves and raise interest rates, economists said. Even small amounts of bond sales could nudge up the cost of home loans.

    Freddie Mac, the McLean, Virginia-based mortgage company, said that the average 30-year fixed rate rose to 5.14 percent for the week ended today, the highest since August. A rise in short-term rates would boost the cost on floating-rate loans for consumers and businesses.

    “If they get this wrong, volatility is going to be through the roof,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. LLC in New York. “Investors are over- discounting the difficulty that is coming our way when the Fed begins the process of raising interest rates.”

    Path of Decline

    The Fed will increase the benchmark rate in the third quarter of 2010, according to the median forecast of economists surveyed by Bloomberg News this month. Vice Chairman Donald Kohn is among officials who have said the recovery needs to be self- sustaining, with the unemployment rate declining, before the Fed tightens. The rate will probably stay at 10 percent in December, according to the median estimate in a separate Bloomberg survey of economists before a Labor Department report on Jan. 8. Unemployment soared to a 26-year high of 10.2 percent in October.

    Fed officials are considering the sequence for using their various tools for withdrawing monetary stimulus. They may start by raising the interest on reserves rate and draining reserves, followed by asset sales, Meyer said in a Dec. 15 research note.

    A second possible sequence would be first draining off excess reserves, then raising the interest on reserves rate later, followed by asset sales, he said.

    “They are going to have to sell assets” to maintain control over the benchmark lending rate, said Brian Yelvington, director of fixed income strategy at bond broker Knight Libertas LLC in Greenwich, Connecticut. “The volatility of the effective federal funds rate around the target is probably going to be a lot greater than it has been in the past.”

    To contact the reporter on this story: Craig Torres in Washington at

    Last Updated: December 31, 2009 18:06 EST