The Federal Reserve has done everything it could to prepare investors for the big policy shift widely expected at its Sept. 19-20 meeting: the gradual unloading of the trillions in government bonds and mortgage securities it sopped up to support the recovery from the financial crisis.
Yet the trickle in maturing debt — initially just $10 billion a month — that the Fed plans to let run off from its balance sheet, rather than continuing to reinvest the principal, may feel more like a torrent thanks to the timing of President Trump's deal with top congressional Democrats to lift the limit on government borrowing until Dec. 8.
That deal essentially means that the Treasury Department needs to unwind all of the extraordinary measures it has taken since March — worth as much as $400 billion — when the government's authority to issue new debt ran out.
The upshot is that there is another big reason why markets may experience some indigestion this fall — call it the reinvestment reflux — as a sequel to the 2013 taper tantrum, when then-Federal Reserve Chairman Ben Bernanke signaled that the Fed was likely to slow its asset purchases later in the year.
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The additional borrowing, on top of the change in Fed policy, could mean upward pressure for long-term Treasury yields, which could be good news for JPMorgan Chase (JPM), Bank of America (BAC) and the rest of the bank sector which has sat out the broad stock market's advance since March, when Treasury yields peaked.
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To keep the government functioning since March, the Treasury has tapped the G Fund of the Federal Employees' Retirement System, which held $225 billion in special-issue government Treasury securities in March. It also suspended payments due to funds covering pension, disability and health benefits for civil service and postal employees.
As of July, the Bipartisan Policy Center said that Treasury had diverted $285 billion from all of those funds, avoiding an increase in public debt of a like amount.
In addition, "Treasury will need to replenish cash balances by as much as $110 billion in very short order," wrote Jefferies Chief Financial Economist Ward McCarthy.
In a sense, you might say that the Treasury conducted its own short-term quantitative easing, taking debt onto its own balance sheet, while lowering the stock of financial assets held by investors.
While Treasury has periodically taken — and reversed — such measures, the stakes are higher now when it coincides with the expected end of an era of central bank intervention, albeit a gradual one.
In addition to the Fed's gradual unwinding of its $4.5 trillion balance sheet, at a pace that will double to $20 billion a month after three months, the European Central Bank is expected to begin tapering its bond buys in coming months.
JPMorgan Asset Management portfolio manager Andrew Norelli believes that central bank balance sheets have been important in "maintaining the buoyancy in financial asset prices." Although the pace of such purchases has slowed, the Bank of Japan and ECB are still accumulating assets at a $1 trillion annual pace. Yet these central banks, including the U.S., could cumulatively be net sellers by mid-2018, Norelli says.
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