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Fed weighs move toward shorter-term portfolio as asset unwind nears end

The Federal Reserve is weighing what kinds of assets its $4 trillion portfolio will consist of going forward, a development that could affect interest rates more broadly and have some ripple effects elsewhere in the markets.

The central bank must first figure out when it will wrap up the monthly cuts from its balance sheet, an effort that the Fed began in 2017 to shed some of its crisis-era asset purchases. Fed officials have signaled they will wrap up the asset redemptions later this year, and more details could come during their March 20 meeting. Analysts expect the balance sheet will end up somewhere above $3.5 trillion once the cuts are over.

The Fed's decision on the size of its balance sheet will pave the way for the central bank to answer another major question: the composition of the assets in its portfolio.

"It's not just the timing [of the end of balance sheet cuts] that matters," said Gregory Daco, chief U.S. economist at Oxford Economics. "Everybody is focused on the timing right now, but it's the what and the how that are also important. So what would the Fed hold and how will it proceed to manage its balance sheet going forward? Those are very important points."

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Right now, the Fed holds roughly $1.6 trillion in mortgage-backed securities, but officials have said their long-term goal is to reduce their presence in that market and instead primarily hold Treasury securities.

Its portfolio currently includes some $2 trillion in longer-term Treasury notes and bonds. But the Fed does not currently hold any shorter-term Treasury bills, which mature in one year or less. The Fed drastically reduced its T-bill holdings during the financial crisis and got rid of them entirely while it was running its "Operation Twist," in which the Fed replaced shorter-term Treasurys with longer-term ones to lower long-term borrowing costs.

In a Feb. 28 appearance, Fed Vice Chairman Richard Clarida laid out the Fed's three options: sticking with a longer-weighted portfolio, moving to a shorter-weighted portfolio or shifting to a portfolio that reflects the maturity composition of outstanding Treasuries. The third option would likely involve the Fed buying up T-bills or other shorter-term Treasurys to move its average duration downward.

"There are pros and cons to any decision we would make," Clarida said at an annual National Association for Business Economics' conference. "There's no slam dunk on this."

Economists are increasingly turning their focus to what the Fed's balance sheet will look like, though they caution that their projections could change depending on how the Fed debate unfolds.

The "only thing set in stone" is that the Fed will move to a largely Treasurys-only portfolio by continuing to get rid of its mortgage-backed securities, Matthew Hornbach, global head of interest rate strategy at Morgan Stanley, wrote in a research note.

The Fed has currently been letting up to $20 billion in mortgage-backed securities roll off the balance sheet every month. Some Fed officials support keeping the monthly cap in place once they reach their desired balance sheet size, thereby taking a more passive approach to doing away with MBS holdings. Others are open to taking a more active approach by gradually selling some of their MBS assets and reinvesting the proceeds into Treasuries.

Jan Hatzius, chief economist at Goldman Sachs, wrote in a note to clients that without any MBS sales, those assets would make up more than 15% of the Fed's balance sheet by the end of 2025. A supplementary program with $5 billion in monthly MBS sales would bring that figure down to less than 10%, he added.

The other major question, though, is to what extent the Fed decides to shorten up its holdings of Treasuries. Some Fed officials said in the December 2018 meeting that having a portfolio that matches outstanding Treasury maturities "would have a more neutral effect on the market" because it would not favor one end of the yield curve, according to minutes of the meeting.

But several others said a portfolio weighted toward the shorter end would give them "greater flexibility to lengthen maturity if warranted by an economic downturn." In other words, they would be able to conduct another Operation Twist to put downward pressure on longer-term rates again and stimulate growth, said Oxford Economics' Daco.

If the Fed does decide to add T-bills to its portfolio, the shift toward a shorter-maturity portfolio would be "more of a glide path" than an immediate switch, said Jay Bryson, global economist at Wells Fargo Securities. But as the T-bill holdings pick up, he added, the currently flat yield curve should steepen a bit as shorter-term yields come down relative to longer-term ones.

"When they first start buying, it's going to have an imperceptible effect on the Treasury curve," Bryson said. "But as they continue to buy more and more bills because they want to increase the stock of bills over time, it would tend to have more of a steeping effect on the curve ... everything else equal."