Point of No Return?

An astute reader and some-time fishing partner raised an interesting issue in connection with a recent commentary. That commentary focused on the problems the Fed faces in designing an exit strategy from its current policy accommodation once the economy really starts to improve and unemployment approaches the FOMC’s 6.5% unemployment trigger point.  Let’s put aside, for the moment, the euphoria that permeated markets last week on the heels of the report that the economy had created 165K jobs in April, and the unemployment rate dropped to 7.5%.  How quickly we forget that March’s number was only 138K jobs, but February’s was a whopping 332K.  What all this tells us is that one month’s number doesn’t constitute a trend.  More to the point, what happens if the economy keeps bumping along as it has, sending signals of hope one minute and concern the next?

Perhaps, as my fishing partner suggests, the problem for the FOMC may not be how to exit, but rather how long it can continue its asset purchase program before its balance sheet becomes too big and the supply of outstanding securities, especially Treasury securities, becomes so limited that markets like the repo market and others that rely upon collateral to function finally reach a breaking point.  As of February 2013, foreigners own about half of the $11.9 trillion of publicly held US Treasury debt, while the Fed owns about 15%, or another $1.8 trillion.  Fed purchases of Treasuries at their current pace of $45 billion per month will add another 5 percentage points per year to the Fed’s ownership share.  Interestingly, these percentages are not far off from the aggregate percentages for the distribution of the ownership of sovereign debt issued by the major central banks of the world.

Two critical concerns and issues arise.  First, it won’t be long before only 30% of US Treasury obligations will be in the hands of private citizens and domestic financial and other institutions.  This trend, combined with recent evidence that the US Treasury may actually begin to pay down the outstanding public debt, portends a squeeze on the outstanding supply of Treasuries, bidding up of their prices, and continued downward pressure on Treasury rates across the term structure.  Second, the squeeze will force institutions into less liquid financial instruments in their quest for liquidity and collateral.  Fed studies the last time there was concern during the Clinton administration that there might be little or no outstanding public debt concluded that only mortgages and mortgage-related securities had markets deep enough and liquid enough to provide a potential substitute.  Knowing, as we do now, just how fragile mortgage markets and the market for mortgage-related securities can be, we question whether such instruments could be an effective substitute without substantial ex ante haircuts.

In short, absent a marked improvement in the economy, the Fed may find that its main problem may not be executing an exit but rather determining how to stop or moderate its asset purchase programs in an effort to stave off what might otherwise prove to be a systemic event for financial institutions and markets.  Given what markets have been conditioned to expect, two challenges will require careful thought: first, how to determine when the red line for asset purchases has been reached and, second, how to convince markets that stopping the program might in no way signal that the Fed is finished with its accommodative policy.  One option available is for the Fed to begin scaling back its purchases of Treasury debt by, say, $5 billion per month while increasing its purchases of mortgage securities by an equivalent amount.  This tack would mitigate potential problems surrounding the market’s use of Treasuries as collateral while maintaining its pace of asset purchases.  A second option would be to expand its securities lending program by the amount of its purchases of Treasuries.  In that way, while the assets would be removed from the marketplace, they would still be available for collateral usage.  All of the above steps would give the FOMC more breathing room and would mitigate any concerns that it might be running out of ammunition.

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