Wednesday, May 9, 2018

The Fed's Treasury Holdings...Reviewing Operation Twist-Off

According to the Federal Reserve, it began normalizing its balance sheet, comprised of mortgage backed securities and US Treasury debt, in late 2017.  In particular, the Federal Reserve holdings of US Treasury's have been reduced by nearly $70 billion since peak holdings.  This is about a 2.7% reduction in the Fed's Treasury holdings, so far.  The Fed plans to continue rolling off Treasury holdings as they mature, at somewhere between $30 to $50 billion monthly, in a "data dependent" fashion likely until they halve their current holdings (give or take hundreds of billions).

But, the make-up of the maturity held by the Fed has really radically changed since Operation Twist ended, even before QE was finally tapered out in late 2014.  The chart below shows the rise and maintenance of long bonds (over 10yrs), the rise and fall of middle duration (5 to 10yrs), especially the emergence of short durations (under 5yrs) and now the surging holdings of the shortest durations of under 1 year.
Below, detailing the holdings by maturity.  The impact of the 2011 Operation Twist (selling everything under 1 year and hundreds of billions in under 5 year duration to fund purchases of mid and long duration) was clear.  Interestingly, when Operation Twist concluded...the holdings of middle duration began falling, and have never stopped falling in what I have termed "Operation Twist-Off".From '09 through early '13 (through QE2), the Fed increased their 5 to 10 year holdings by nearly $800 billion (from $100 billion to $900 B...or a 900% increase...likewise, about a $550 billion increase in long duration, or about 550% increase).  QE 3, essentially beginning in 2013, was used to fund the surge in 1 to 5 year debt as well as top off the "over 10 year" holdings...and adding nothing to the 5 to 10 year bucket.  Then, the Fed began reducing its 5 to 10 year holdings beginning in 2014 ("Operation Twist-off" and from that time on, the Fed has persistently sold off nearly $600 billion (or 66%) of its 5 to 10 year holdings.  Meanwhile, the Fed has rolled off less than 7% of its long duration, just 3% of its 1 to 5 year duration portfolio, and increased its holdings of less than a year maturity Treasury's by about $400 billion.  At this rate, the Fed will be back to its pre-GFC level of 5 to 10 year holdings sometime in 2019 (the Fed's holdings of under 1 year maturity are already back to their pre-GFC level).  At that point, the Fed will have nothing to roll off or sell but short and/or extremely long duration if it intends to further shrink its balance sheet.I'm "amazed and shocked" that as the Fed focused its balance sheet reduction solely on mid duration holdings and bought short duration...the short end rose significantly visa-vis the mid and long duration.  So important to note that as all recognizable sources of Treasury buying (save for one) have wound down, ceased, or turned to outright selling...prices and yields haven't reflected this "free market" implication despite continued record federal trade and budget deficits. As a reminder, you are welcome to read about who hasn't been buying US Treasury debt HERE...and who has done all the buying HERE pre, during, and post QE.  In a situation where nothing adds up, that in itself adds up (likewise, remember, Bernie Madoff's #'s never added up, and that was the point).

Fascinating that as the Fed began (and continued) dumping 5 to 10 year debt in 2014 and subsequently ceased QE in late 2014, the two largest foreign holders (China/Japan) would both turn to net sellers while the BLICS (Belgium, Luxembourg, Ireland, Cayman Island, and Switzerland) would take over the heavy lifting of maintaining the foreign bid for US Treasury debt.
And interesting to note that Ireland is the new Belgium, leading the way for shadow banking centers (outside the purview of regulators...or regulations, period) to maintain the bid (and control the yields) for US debt...most likely loaded to the gills with 5 to 10 year US Treasury debt?!?  Why and how the proxy known as "Ireland" added $300 billion in US Treasury debt to the paltry $15 billion held there as of 2009 and superseded Belgium (of all countries) to became America's #3 foreign creditor is a story in itself.
Regardless the BLICS efforts, the remainder of foreigners have eschewed US debt to such a degree that foreign holdings as a whole have essentially stalled since the Fed ceased QE.  This has left the domestic sources to do nearly all the buying.
These domestic sources of buying are led by that juggernaut of funding known in the Treasury reports as "other".  Not domestic banks, not domestic pensions, not insurers, not state or local it's mutual funds assisting the massive bid from "other", loading up like never before on US Treasury debt and saving America from interest rate Armageddon.  Even "banana-republics" dare not turn their national finances and currency into such a clear farce...but then again, they haven't the greatest military force on the face of the planet.
The implications of the Fed having sold off the middle duration while holding all its long duration and buying short duration, well that just may have had some impact on the yield curve.  Perhaps the "professionals" will be good enough to outline the theoretical vs. practical impacts of the Fed buying short duration, dumping mid duration, and holding long duration should have and actually did have on the yield curve.  And vice versa once all the mid duration debt is gone and the Fed has nothing to sell but short and/or long duration.

And just a reminder below of the interplay between the Fed's balance sheet reduction in Treasury's versus bank excess reserves.  Clearly, since QE ended, excess reserves are finding their way out and into the economy (effectively pure monetization that is leveraged maybe 2x's to 8x's...thus $700+ billion turns into $1.5 trillion to $6+ trillion in new hot money since QE ended).  So much for the "Fed will never monetize the debt".
Some may ask "why"?  Why is all this seemingly ludicrous and seedy activity taking place?  Simply put, the world is maturing and as things do this...growth slows and activity can plateau or even subside...but a poorly twisted economic and financial model run by immature "powers that be" cannot and will not (willingly) accept what the world can organically bear.  So, as I have detailed seemingly in a hundred different ways in far too many articles (links available on the sidebar of the blog), every lever is being pulled and every future income spent to maintain the appearance of growth and prosperity in the here and now.  Very sadly, there will soon be a terrible price to pay for this hubris.