What the Fed has been buying for its own account – and why.
What’s behind the changes in the Fed’s buying and selling of assets for its own inventory? Two patterns have attracted particular attention in recent months: the growth in overall assets, and the jump in ultra-short term asset purchases (i.e., repos) to counter mismatches of supply and demand in money markets.
Federal Reserve Balance Sheet, Monthly Change in Assets
Chart courtesy of Western Asset. Source: Federal Reserve, Western Asset, as of 12/31/2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The resumption of balance sheet expansion in recent months is consistent with the Fed’s clearly stated objective of supporting economic growth via low interest rates, as well as quantitative easing. Western Asset expects this overall stance to continue well into the year, especially as global macro factors such as the spread of coronavirus add to existing geopolitical and economic stresses.
However, the regular use of short-term repos to make up for the inability of money markets to find willing lenders at prices consistent with Fed policy is an ad-hoc policy fix that the Fed is currently working to replace. The Fed’s own statements suggest that a more durable solution will be a standing repo facility, the details of which have yet to be determined.
On the rise: Buenos Aires creditors
Holders of Buenos Aires bonds succeeded in forcing the province to pay $250 million, originally due at the end of January, instead of accepting the province’s proposal to delay the payment until May.
Holders of Argentina’s sovereign debt reacted to the concession with optimism, viewing the deal as a sign that their negotiating position with the country was stronger than previously believed. That belief may have been responsible for the rally in Argentina’s 2028 bonds, which climbed 1.56 cents to 46.6 cents1 on the dollar.
On the slide: U.S. Breakeven Inflation
U.S. Treasuries continue to trade as if inflation is likely to remain under pressure. Break-even inflation, reflecting the implied inflation rate embedded in the price differential between Treasuries and Treasury Inflation-Protected Securities (TIPS) of the same maturity, has continued to trend down since the beginning of 2020. As of the end of trading on February 4, 5-year breakeven inflation was just under 1.6%. The New York Fed’s in-house breakeven inflation rate was1.68% as of January 31, the most recent figure available.
It’s important to note that these rates are well-understood to be volatile, and not reliable as predictors of inflation over the long run. As measures of general market sentiment, however, there are directionally useful, and suggest that the Fed may have its work cut out for it to move expectations for future inflation toward, if not above, its longstanding 2% target for general inflation.
Note: The year for all dates is 2020 unless otherwise indicated
1 Source: Bloomberg. Feb 4, 2020, 4:00 PM ET
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
A repurchase agreement, or repo is a contract under which the seller commits to sell securities to the buyer and simultaneously commits to repurchase the same (or similar) securities from the buyer at a later date (maturity date), repaying the original sum of money plus a return for the use of that money over the term of the repo. If the collateral has a volatile price history the buyer is at risk. To reduce this risk, a haircut is imposed. The haircut is some percentage of the market value the buyer holds back from the cash payment to account for the price volatility as well as counterparty risk.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
U.S. Treasury inflation protected securities (TIPS) are a special type of Treasury note or bond that offers protection from inflation. Like other Treasuries, an inflation-indexed security pays interest six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the CPI. Also referred to as “Treasury inflation-indexed securities.”