Trend: The Federal Reserve has been buying U.S. long-term U.S. debt to support lower interest rates and the economic recovery.
The authors of this commentary suggest that Fed's debt buying actions appear to be unsustainable. Excerpts below.
...foreigners are selling longer dated US Agency/MBS debt and moving the money they raise into shorter term US Treasury debt. And who is buying this debt? The Federal Reserve.
Out of nearly $2.1 Trillion of net issuance across the Treasury, Agencies and MBS markets from June 2008-9, the Federal Reserve has accounted for nearly 40% of the total demand, buying more than every foreign government combined. It is also not a stretch to say the Fed has become the entire mortgage market; it has purchased nearly $500B of MBS securities during a period where there was only $350B issued. Looking at the first seven calendar months of 2009 yields similarly startling results: of the total $1.1 Trillion of net issuance across these markets, the Fed has purchased $861B or almost 80%.
The question we must all grapple with is what will happen when the Fed has completed its purchases. According to the US Treasury’s Department of Debt Management, the US is expected to issue $1-1.6 T of Treasury debt in the 2010 fiscal year. This implies that total US government market issuance next year could once again run in the $2T range. To make up for the Fed’s nearly $900B worth of purchasing would require the recently elevated household savings rate to double from 6% to 12%. Commercial banks, which have purchased nearly $200B of US debt in the same time period, would also need to double that amount again from this past year.
If the Fed simply walks away or even gradually moves away from the market, we will see bond market prices drop and mortgage and all other rates go higher, potentially crushing the nascent recovery. The CEO of Wells Fargo recently told a group of investors that if the Fed stopped buying MBS, mortgage rates could spike 100-150 basis points in a week.
If the economy turns down, sparking a flight to safety in Treasuries, the Fed will once again have to worry about deflationary expectations and respond by printing money.
Unfortunately, printing more money, expanding its balance sheet further, and hoping to “kick the can down the road” may not be a viable strategy for the Fed much longer either as nearly two-thirds of the US government debt comes due in the next 36 months.
The Federal Reserve, through a confluence of past mistakes, effective crisis response, and circumstance has found itself trapped with only painful options from which to choose.