How and When Will the Fed Reverse the Huge Addition to Bank Reserves?

The Fed continues to expand bank reserves (first chart), but its balance sheets remains relatively unchanged in aggregate over the past year (second chart, source here). Further, as seen in the second chart, the Fed has bought enough Treasury bonds by now to replenish what it "lost" in last year's panic, flight-to-quality. They will continue to buy agency and mortgage-backed securities, but these purchases will likely be offset by declines in the "other" categories.

The big question thus remains: how and when will the Fed start reversing this huge addition to bank reserves? The Fed will eventually have to sell, by hook or by crook (and it is already experimenting with ingenious ways to do this) about $1 trillion worth of agency and MBS. Whether this by itself will push interest rates up, or whether rates will rise because the economy is picking up and that is the justification for the Fed to reverse its liquidity injections, it doesn't much matter. The bottom line is this: if the economy continues to grow at a 3-4% rate, as seems likely to me, then interest rates on Treasury bonds are going to go up significantly, and rising Treasury yields will in turn push agency and MBS yields higher as well.

The market is currently happy with 3.5% yields on 10-yr T-bonds, but only because the market doesn't believe that this economy has the potential to post continued, decent rates of growth. If and when that perception changes to one of expecting 3-4% growth (or even more: see my previous post), then Treasury yields will inevitably move significantly higher. So it's not worth your time worrying about how the Fed will reverse its quantitative easing; the main driver of interest rates will be economic growth. And of course inflation is going to play a role in rising rates as well, but the market won't worry about inflation until it first becomes convinced that the economy has the ability to grow by at least some decent rate.

When it comes to Treasury yields, it's all about economic growth.

Comments

[Dave Wrixon:]

Ha, Ha, Ha. Very amusing!

What is clear from that is the ongoing support for Mortgage backed securities is putting the balance sheet under real strain, and because the housing market is in many ways getting worse, that strain is going to stretch the Fed to breaking point.

Once of three things has to happen here, either the Fed start to expand its balance sheet at a much faster rate, support for the housing market stops, or the Fed starts junking Treasuries.

It is also clear that the quality of the debt that the Fed is holding is going South rapidly.

Oct 30 08:12 AM

[Living4Divi...:]

"How and When Will the Fed Reverse the Huge Addition to Bank Reserves? "

That's the One Trillion Dollar Question !

Oct 30 11:05 AM

[Dave Wrixon:]

How can it when it is all held in Mortgage backed securities? To unload those, doesn't it have to sell? Who the hell is going to buy?


On Oct 30 11:05 AM Living4Dividends wrote:

> "How and When Will the Fed Reverse the Huge Addition to Bank Reserves?
> "
>
> That's the One Trillion Dollar Question !

Oct 30 03:31 PM

[Smarty_Pants:]

"Who the hell is going to buy?" - Dave Wrixon

This is the dirty little secret of the Keynesian camp. The only way the FED can really reduce their balance sheet now is to start writing the toxic MBS assets off as total losses.

Naturally the odds of the gub'mint bailing them out at that point are pretty good, so Joe Sixpack will be the one whose standard of living suffers as a result.

Oct 30 10:38 PM

[Dave Wrixon:]

Unfortunately, writing down the value of the securities does not provide a mechanism for reducing the excessive creation of money. All it does is make it permanent. Once this is understood then dollar is toast because Inflation Depression will be unavoidable.


On Oct 30 10:38 PM Smarty_Pants wrote:

> "Who the hell is going to buy?" - Dave Wrixon
>
> This is the dirty little secret of the Keynesian camp. The only
> way the FED can really reduce their balance sheet now is to start
> writing the toxic MBS assets off as total losses.
>
> Naturally the odds of the gub'mint bailing them out at that point
> are pretty good, so Joe Sixpack will be the one whose standard of
> living suffers as a result.

Oct 31 06:34 AM

[Bruce Krasting:]

Not at all worried about how they will unwind this? I am.

Oct 31 09:25 AM

[morph366:]

I seriously don't mean this to be taken as offensive but when I read most of your contributions I am reminded of the expression.

"For every problem there is one solution which is simple, neat, and wrong."

Oct 31 01:29 PM

[KirbyJF1:]

Where is all that inflation you talk about? You better do a lot more investigating as to where money is going. ((its Savings accounts & paying off debt)) Thats not inflationary.

Kirby

Oct 31 01:36 PM

[bob adamson:]

KirbyJF1 -

You are correct in the near term for sure. In the longer term, whether inflation will occur depends on the timing and circumstances whereunder the accumulated debt obligations of the Fed are discharged. More about this in my response below to Dave Wrixon.

Dave Wrixon -

Your prediction of an inflationary depression may come to pass but, arguably, the odds are that this can be avoided.

Clearly the implicit assumption of the Federal Government and the Fed is that part of both
1. the face value of the toxic assets purchased by the Fed from the banks, and
2. the TBs purchased by the Fed to fund the Federal Government deficits
must be monetized at some point in time. The hope must be that that part to be monetized (and thereby a trigger for inflationary pressure at some point in the future) will be as small as possible (i.e. that there will be sufficient
1. re-inflation to breath some value back into the toxic assets,
2. increased earnings by those who are obligated to make payments on the loans that underlie toxic assets, and
3. increased Government revenue to support the greater part of this debt before it must be resold, realized or monetized by the Fed)
and that the moment of truth will occur well after the economy generally is on a firmer footing than at present. To that end, the hope must be that the residential and commercial real estate market improves significantly and the employment situation begins to turn around before market pressure for increased interest rates grows.

Arguably too many of us criticize the Fed and Federal Government for incurring the greater debt burden (i.e. these toxic assets and TBs) over the past 18 or so months. Some argue that a deep recession/depression was unavoidable and it would have been best to let the liquidation of debt and constructive destruction occur unhindered. Others object to the aid given to the banks and auto industry. The rebuttal argument is that the alternative (in the form of human misery, economic chaos and destruction of essentially sound enterprises and institutions) to this fiscal and monetary stimulus was too great a price for the society and that this stimulus (intelligently deployed in sufficient amounts) represented a reasonable prospect of bridging the chasm back to economic recovery. History will show which argument is right. The next twelve months may well be crucial in the determination whether the stimulus approach (and the Feds debt burden that stimulus entailed) is manageable and a viable tool to allow recovery to begin.

Oct 31 10:57 PM

[Joe Snow:]

The Fed is in a quandry when it comes to raising rates/removing liquidity. There are still a lot of mortgages out there that were spared from foreclosure by the fall in interest rates. As soon as rates start to rise, we will see the foreclosures begin anew as ARM's adjust upwards and holders of bad mortgages start to default again. I hope none of you bought a house recently thinking this was the bottom.

Oct 31 11:13 PM

[Tony Daltorio:]

The Fed will NEVER remove the huge additions to bank reserves.....

Nov 01 11:34 AM