Shrinking Deficit Likely to Help Fed Reduce Bond Buys

Photograph by Scott Eells/Bloomberg

Traders work on the floor of the New York Stock Exchange (NYSE) as Ben S. Bernanke, chairman of the U.S. Federal Reserve, speaks on television in New York.

When the Federal Reserve announced it would purchase $45 billion a month of Treasury bonds to support the economy, it probably anticipated there’d be plenty to buy. After all, the Fed made its December announcement just a few months after the Treasury closed out the 2012 fiscal year with a $1.09 trillion deficit.

Yet last week the Congressional Budget Office estimated the deficit will shrink to $642 billion, the smallest shortfall in five years. Suddenly the Fed’s purchases, which work out to an annual pace of $540 billion, are poised to gobble up almost all the new debt the U.S. will issue next year.

That may be a winning situation for the Fed, where policy makers are seeking to eventually shrink their monthly purchases. A reduction would push up bond yields and raise borrowing costs across the economy.

“If the Treasury reduces supply as the Fed reduces purchases of Treasuries, then your net impact on yields should be left unchanged,” said Drew Matus, deputy chief U.S. economist for UBS Securities LLC in Stamford, Connecticut, and a former analyst on the New York Fed’s open market desk.

The Treasury Department will sell less debt as surging tax revenue, automatic spending cuts and payments from mortgage-finance companies Fannie Mae and Freddie Mac narrow the budget gap. All else equal, that shrinking supply of Treasuries should put downward pressure on yields.

The Fed owned $1.86 trillion of Treasury securities as of May 15, according to its weekly balance sheet report. That’s about a sixth of the $11.4 trillion in total outstanding marketable U.S. debt. Much of that supply may be held by investors or institutions that don’t intend to sell their holdings.

While the falling supply of Treasuries could help when the Fed wants to slow its purchases, it could create a headache for the central bank if it instead wanted to continue the program. By buying so much U.S. debt, the Fed could dry up liquidity in the market.

Under the current bond-buying program, known as QE3 for the third round of quantitative easing, the Fed is purchasing $45 billion a month of Treasuries and $40 billion a month of mortgage-backed securities.

One reason for concern about the health of markets: In its first round of QE, when the Fed bought $1.25 trillion of mortgage bonds, the market for those bonds malfunctioned. The Fed bought so much that Wall Street was unable to complete an unprecedented amount of trades. Weekly failures to deliver or receive mortgage debt climbed above more than $1 trillion in 2010, compared with a weekly average of $150 billion in the five years through 2009, according to Fed data.

The open-ended nature of the current QE program could create a new shortage in the Treasury or mortgage market as the Fed’s balance sheet grows, said Stephen Stanley, the chief economist at Pierpont Securities LLC in Stamford, Connecticut.

“The longer QE goes on, the more likely it is to be more of a problem from a liquidity standpoint,” said Stanley, a former Richmond Fed economist.

If the Fed is happy with the economy’s progress, it may be an easy decision to slow their purchases. If they want to keep going full speed ahead, the falling deficits may present a challenge.

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