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The Fed’s next big decision may not be about rates

Bond investors may be missing a bigger question.

Bond investors looking to the Federal Reserve next week for hints about when it will be ready to lift interest rates for the first time since 2006 may be missing a bigger question.

With policy makers seemingly making little progress on their path to raising rates, they’re also delaying resolving how they approach the $215 billion of Treasuries poised to mature and roll off the Fed’s balance sheet next year, and almost $800 billion through 2018. That’s creating uncertainty about a less-publicized issue for the central bank: how it plans to reinvest proceeds from holdings of government bonds amassed since the financial crisis, and whether it may do so in a way that addresses rising bond-market volatility.

Expectations for the removal of policy accommodation through higher interest rates have exacerbated a decline in liquidity in the market for U.S. government debt. To confront this, the Fed could restock its Treasury portfolio by buying older securities in the secondary market, rather than its customary method of buying new issues directly from the Treasury, according to Aaron Kohli, a fixed-income strategist at Bank of Montreal, one of 22 primary dealers that trade with the central bank.

“One approach benefits market liquidity in the short-term, the other doesn’t,” Kohli said. “If you suppress volatility, the market can become a lot easier to trade in the near term. They’ve talked a lot more about Treasury-market liquidity and they’ve spent a lot of time investigating it.”

The yield on the 10-year Treasury note rose five basis points last week, or 0.05 percentage point, to 2.09 percent Friday in New York, according to Bloomberg Bond Trader data. The 2 percent U.S. security maturing in August 2025 traded at 99 7/32.

Market-Making Role

Few in the market think the Fed will simply stop reinvesting, given that such a decision would force the Treasury to sell more debt into the open market. Buying bonds in the secondary market could help the Fed offset rising volatility by stepping into a function traditionally filled by banks, as many retreat from market-making roles amid stricter regulations.

The Fed’s balance sheet includes $2.46 trillion of Treasuries, up from about $800 billion before policy makers began taking extraordinary steps in 2007 to bolster the banking system under the stress of a decline in the housing market.

Any policy innovation should start with an attempt by Fed officials to signal their intentions, according to Michael Lorizio, senior trader with Manulife Asset Management in Boston.

“It seems possible they could do something like” changing their reinvestment strategy “if they were concerned about the economy,” Lorizio said. Without proper warning from officials, “that would send a message they don’t want to send.”

Disconnected Rhetoric

Fed Chair Janet Yellen’s recent statement that she expects the central bank to raise rates this year is at odds with market predictions amid signs of slowing global growth.

Interest-rate futures indicate the probability of an increase this year has fallen to 36 percent from 59 percent at the beginning of September. The first month where the market sees the Fed lifting off is March, with a 60 percent likelihood, Bloomberg data show. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.

With futures traders assigning only a 6 percent probability that the Fed will raise rates at its Oct. 27-28 meeting, investors will be parsing the Fed’s statement for signs of any pending policy shift.

“What’s more important than anything the Fed says about hiking rates this year or not next week is any details they provide around their reinvestment policy,” Kohli said.

While the central bank must address the topic of balance-sheet management at some point, quelling uncertainty about its policy intentions remains the Fed’s most pressing priority, according to Thomas Simons, a money-market economist at Jefferies Group LLC in New York, a primary dealer.

“There’s a significant difference of opinion in how to interpret what they’re doing,” Simons said. “That’s a problem they need to solve immediately.”

©2015 Bloomberg News

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