[Fed] Waller: Reversed Operation Twist?

Remarks of Officials

Summary:

The Federal Reserve should increase the proportion of shorter-dated Treasury securities in its balance sheet and reduce its holdings of agency mortgage-backed securities (MBS) to zero.

Fed Governor Christopher Waller spoke at the U.S. Monetary Policy Forum on March 1 (EST) on quantitative tightening, with the key points as follows.

Waller expected two results regarding the long-term issues related to the Fed's portfolio:

Firstly, he would like to see agency mortgage-backed securities (MBS) reduced to zero because these assets are less liquid and are reduced more slowly, with the average reduction in MBS being about $15 billion per month. The underlying mortgages have very low interest rates and prepayments are quite small.

Secondly, he would like to increase the proportion of shorter-dated Treasury securities. Before the global financial crisis, about one-third of the Fed's portfolio was shorter-dated Treasuries. Today, the size of shorter-dated Treasuries is less than 5% of the Treasury holdings and less than 3% of the total portfolio size.

On the one hand, increasing the share of shorter-dated Treasuries would allow the Fed to better adjust the maturity structure of assets on its balance sheet to more closely match the overnight federal funds rate. On the other hand, holding more short-term Treasuries would link the Fed's investment income more closely to its interest payments to banks.

In addition, increasing the proportion of shorter-dated Treasuries means that the Fed can more flexibly adjust the size and structure of its balance sheet. By not renewing shorter-dated Treasuries at maturity, the Fed can avoid the need to purchase or hold large amounts of additional long-term assets when providing liquidity support to the market, thus controlling the growth of the total size of its balance sheet.

The balance sheet deduction (Quantitative Tightening, QT) and the decision to determine the U.S. benchmark interest rates are independent of each other. Also, whether or not to increase the share of short-term Treasuries will be a matter for the FOMC to decide over the next few years.

Note: Waller's view to "buy short-term bonds and sell long-term bonds" is similar to the Fed's previous " operation twist", except for the operation of "selling short-term bonds and buying five-year U.S. Treasury bonds" during the 2011-2012 period to reduce the interest rates on long-term bonds. This can reduce the borrowing cost of small and medium-sized enterprises and stimulate the economy. Waller's remarks can be interpreted as a "reversed operation twist".

After Waller's speech, the interest rate-sensitive two-year U.S. bond yields fell further by more than 10 basis points to 4.52%, the lowest level since February 15th. Longer-dated U.S. bond yields fell less, with the 10-year U.S. bond yield falling by 6 basis points to 4.18%. The degree of inversion of the U.S. bond yield curve eased.

We can see the impact of Waller's comments on the bond market.

On the same day, Dallas Fed President Lorie Logan repeated that with bank reserves decreasing, the Fed may begin to slow down its pace of balance sheet shrinking.

Waller and Logan's remarks came at an opportune time, as the Fed's overnight reverse repurchase agreement (RRP), the Fed's liquidity adjustment facility, had $128 billion of liquidity drained in two days. The balance dropped by 22% to $441.265 billion, below $500 billion again since February 15.

Moreover, the Fed's emergency bailout tool, the Bank Term Funding Program (BTFP), was launched during last year's banking crisis. It will expire in March and will not be renewed, and banks will be forced to fund their $160 billion shortfall through the discount window.

All of these suggest that liquidity risks may be concentrated in March, and the Fed will be forced to stand at the crossroads again. At this particular moment, Waller's speech may not be a "coincidence", and it may become one of the Fed's choices, but it also means that the path of balance sheet shrinking may be adjusted greatly.

Waller's Speech

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[Fed] Waller: Reversed Operation Twist?

Waller's Speech

Risk Disclosure