Joseph Wang | April 7th, 2022
The QT Plan
The Fed’s March minutes sketched out a plan for QT that was as aggressive as promised. The maximum monthly redemption cap this time around will be $95b, almost double the $50b cap from the prior QT. It will be split between $60b in Treasuries and $35b in Agency MBS, with some potential for Agency MBS sales down the line. Mechanically, QT means the U.S. Treasury is refinancing Fed held Treasuries by borrowing from the private sector (see here for details). In the next three years the private market will be flooded with historically high net new issuance, as well as QT issuance flows. Longer dated Treasuries have already aggressively sold off in anticipation, but the selling is likely far from over. This post will review the Treasury and Agency MBS QT plan and its potential market implications.
Treasury QT is expected to ramp up quickly to a maximum pace of $60b a month, with one slight change from the prior QT. This time around the Fed will let its $330b in bill holdings gradually roll off when monthly maturing coupons are below the $60b redemption cap. For example, $10b in bills will roll off if there are only $50b in maturing coupons. A sketch of the Fed’s Treasury QT based on its current holdings, a quick ramp up and ramp down period, and expected 3 year time frame leads to about $2t total in Treasury QT.
The market impact from QT will largely depend on how the Fed held Treasury securities are refinanced by the U.S. Treasury, which has discretion in the tenors of Treasuries it issues. The curve would steepen if it decides to issue longer dated debt to lock-in historically low rates, or it would be little changed if it decides to issue more bills and soak up the enormous $1.7t in the RRP facility. In general, the Treasury aims to have 15 to 20% of its debt in bills. Under this guidance any amount of issuance will be comprised substantially of coupon securities, and thus place upward pressure on term premium. Aside from QT, Treasury is already forecasting historically high net new issuance of ~$1.5t a year for the next few years. Together with QT, the private market will have to absorb a staggering ~$2t in issuance each year for the next 3 years.
The Fed plans to cap Agency MBS redemptions at $35b a month, which is notably above expected monthly maturities. The New York Fed estimates that monthly principal paydowns going forward will average around $25b a month, so the caps will not be binding. Note that U.S. mortgages are prepayable so the expected principal payments are always model driven, though with historically low mortgage rates behind us there is little chance of large prepayments. The non-binding caps are likely designed to provide flexibility for Agency MBS sales, which the minutes also allude to. The current roll off pace of ~$300b a year should be sufficient for the Fed to achieve it’s ideal balance sheet size, but if not then outright sales are an additional lever.
Unlike Treasury QT, Agency MBS QT will likely not increase the amount of duration the held by the private sector. Mortgages are paid down either via refinancing or monthly P&I payments. When a Fed held mortgage is refinanced, the borrower effectively repays the Fed using a loan from a private sector entity. This would increase the duration held by the private sector. In the current context refinancing will be limited as mortgage rates look to remain above recent historic lows. Principal paydowns will thus come out of the monthly payments made by borrowers. However, Fed outright sales would increase private sector duration.
The Great Steepening
Going forward the supply of duration in the market will be historically high at a time when rates are still historically low. This will occur amidst multi-decade high inflation, vanishing Treasury market liquidity, and binding balance sheet constraints. Commercial banks, a significant marginal buyer last year, appear to have stepped back from the market this year. Foreign buyers, another marginal buyer, are facing steeply increasing FX hedging costs from rate hikes. In this context, much higher yields will be needed to draw in new investors.
Joseph spent 5 years studying the plumbing of the financial system as a senior trader on the open markets desk. The Desk sits at the center of the dollar system as its ultimate and infinite provider of dollars. It has access to virtually all regulatory and financial data, as well as open lines of communication with all major market participants. It is one of the few places in the world where one can definitively learn how the system works.
Prior to joining the Desk, Joseph was a credit analyst and in another life he practiced law. He holds a B.A. in Economics from Northwestern University, a J.D. from Columbia Law School, and an MSc. in Financial Economics from Oxford University.
His book: Central Banking 101
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