Joggers pass the Marriner S. Eccles Federal Reserve building in Washington, D.C., on Tuesday, Aug. 18, 2020.
Erin Scott | Bloomberg | Getty Images
While the Federal Reserve may not raise its benchmark interest rate for years, there are growing expectations it may tweak policy soon to address some of the recent tumults in the bond market.
The moves could happen as soon as the upcoming March 16-17 Federal Open Market Committee meeting, according to investors and economists who are watching recent action closely and expect the central bank to address some distortions that have occurred.
One possible move would the third iteration of Operation Twist, a move the Fed last made nearly a decade ago during market tumult around the time of the European debt crisis. Another could see an increase in the rate paid on reserves to address issues in the money markets, while the Fed also might adjust the rate on overnight repo operations in the bond market.
The mechanics of Operation Twist involve selling shorter-dated government notes and buying about the same dollar amount in longer-duration securities. The objective is to nudge up shorter-term rates and drive down those at the longer end, thus flattening the yield curve.
The Fed ran the program both in 2011 and in 1961; a market participant familiar with the Fed’s operations said central bank officials have been in contact with primary dealers to gauge the need for some intervention.
‘The perfect policy prescription’
Longer-term bond yields have surged over the past two weeks to levels not seen since before the Covid-19 pandemic. While they remain low historically speaking, markets have been concerned over the pace of the increase. The bond market was calm Monday, with rates in the middle of the curve mostly lower.
Implementing the scheme could help soothe some of the jangled nerves that accompanied a recent blast higher in interest rates from 5-year notes on up the curve. The “twist” is a nod toward adjusting the duration of its purchases to the longer end, and the buying and selling of equal weights mean the Fed’s already bloated $7.5 trillion balance sheet won’t be expanded further.
“The Fed is simultaneously losing control of both the US front end & back end rates curves for different reasons,” Mark Cabana, rates strategist at Bank of America Global Research, said in a note to clients. “Twist, a simultaneous selling of US front end Treasuries & buying of longer-dated [bonds], is the perfect policy prescription for the Fed, in our view.”
Cabana said the move “kills three birds with one stone.” Namely, it raises rates on the short end of the duration spectrum, provides stability on the back end and does not expand the balance sheet and thus require banks to hold more capital.
“We believe no other Fed balance sheet option can address each of these issues as effectively,” he wrote. “To be clear the Fed will twist to deal with market functioning issues, not economic problems.”
Indeed, the Fed is welcoming some upward pressure on yields as it reflects a growing economy and rising inflation expectations toward the central bank’s 2% goal.
However, the trend presents some issues for the Fed that a weak 7-year note auction last week helped demonstrate. The Fed needs bond auctions to go well as a surge in supply is on the way from a federal government running what is expected to be a deficit of at least $2.3 trillion this year.
Investors tend to shy away from longer-dated bonds during times of inflation as their rates can’t keep up and cause bondholders to lose principal. That’s why Cabana expects the Fed to sell $80 billion a month in Treasury bills and use it to buy bonds of duration past four and a half years.
FOMC members at their November meeting discussed market expectations that the central bank would begin to lengthen the average duration of its purchases. Members endorsed “ongoing careful consideration” of the composition of its bond holdings.
“Participants noted that the Committee could provide more accommodation, if appropriate, by increasing the pace of purchases or by shifting its Treasury purchases to those with a longer maturity without increasing the size of its purchases,” the minutes from that meeting stated.
Raising rates on reserves and repo
There are other issues in the market, and that’s why the Fed’s actions may not be limited to Operation Twist.
One other move it could do is increase the interest on excess reserves rate from 0.1% to 0.15%. Though there essentially are no excess reserves now due to the Fed dropping the minimum during the Covid-19 crisis, the IOER serves as a guardrail for some short-term rates, which is important to money market funds that have had to buy bills at negative real rates.
“The Fed essentially has to place a raised floor in the U.S. economy to keep things that need positive returns alive,” said Fed veteran Christopher Whalen, head of Whalen Global Advisory.
While he said he understands the IOER move, Whalen said he is skeptical of how successful the Fed will be with implementing Twist.
“No matter how well-intentioned they are, their efforts to engineer things are slowly weakening the system,” he said. “You have another bad auction or two and we’re screwed.”
Still, Cabana said expects the Fed to begin signaling the additional moves as soon as this week. Chairman Jerome Powell speaks Thursday during a Wall Street Journal event, and a slew of other Fed officials also are on tap to share their views this week.
Markets worried over how things are running likely will welcome the Fed’s moves, said Joseph Brusuelas, chief economist at RSM.
In addition to the Twist implementation and adjustment on IOER, Brusuelas thinks the Fed also will increase the rate it pays on overnight repo operations from zero basis points to five.
While Brusuelas said markets expected rising rates this year, “what we didn’t expect was an overreaction to the reflation of the domestic economy in the fixed income market. That clearly has gotten the attention of the Fed.”
“The market would welcome the lifting of the IOER as well as any communication that it intends to twist the curve down to keep the economy on track,” he added.