On Nov. 3, the Federal Open Market Committee indicated the economy had met the committee’s targets to begin reducing the pace of its U.S. Treasury and mortgage-backed security purchases by $15 billion per month. While history has shown that Treasury yields fall while the Fed is engaged in a balance sheet taper, the market initially reacted by sending Treasury yields higher.
Despite conclusive data following quantitative easings 1, 2, and 3, when Treasury yields fell during a taper or termination of the program, investors believe this time is different. The overarching belief today is that yields would be significantly higher had the Fed not intervened with quantitative easing.
The reason investors believe yields would be higher had the Fed not intervened and that yields are headed higher is because of the lack of demand or desire to own Treasury securities. There’s little evidence to support that view. Due to the design of the banking system, there’s a persistent demand for U.S. government debt.
The commercial banking system is reserve-based. In a reserve-based system, customer deposits are used to purchase Treasury securities with an average duration of 5 to 7 years. A Treasury security that has been purchased with a commercial bank’s customer deposit is referred to as a “bank reserve.”
When the Fed engages in quantitative easing, it swaps bank reserves with an overnight reserve or what is referred to as a “reserve asset.” The result of the exchange is that the customer’s deposit is now backed by the Fed instead of the U.S. Treasury.
From a customer’s perspective, they have no knowledge or indication their deposits are being used to purchase Treasury securities or if they’re being backed by the Federal Reserve. It’s the interest from those Treasury securities and reserve assets that are used to pay interest on the customer’s deposit.
When the Fed engages in quantitative easing, it forces the commercial banks to create bank reserves with Treasury and mortgage-backed securities of the Fed’s choosing. Under normal conditions, a commercial bank wouldn’t purchase a 30-year Treasury security to back a customer deposit that’s likely to remain on the bank’s balance sheet for 5 to 7 years.
During a quantitative easing operation, the Fed can force the banks to purchase any type of security the Fed wants. By controlling which securities a bank must purchase to create bank reserves, the Fed can attempt to suppress or lower a specific part of the yield curve. By reducing or stopping its asset purchases, all the Fed is doing is ceasing to target a specific part of the yield curve.
As long as commercial bank deposits continue to increase, the commercial banks must continue buying Treasury securities. The only difference is that the commercial banks will not be forced to purchase specific securities as dictated when the Fed is engaged in quantitative easing.
To encourage demand for longer-dated Treasury securities, earlier this year the Fed announced a standing repurchase agreement facility (SRP) that allows securities dealers to post Treasury and agency-backed securities for overnight dollar loans. The purpose of the SRP was to provide liquidity across the entire yield curve. Recently, the Fed made the SRP available for commercial banks to use.
Currently, commercial banks use customer deposits to purchase Treasury securities with an average duration of 5 to 7 years, which matches the average time a customer deposit stays at a bank. By opening the SRP to the commercial banks, the commercial banks can purchase longer-dated Treasury securities with customer deposits, knowing they can go to the SRP for cash at any time should there be an unanticipated increase in withdrawals.
Customer deposits have shown no signs of slowing, which means the demand for Treasury securities will continue to be high as the commercial banks must purchase Treasury securities to convert customer deposits to bank reserves. Further supporting the demand for U.S. government debt are the commercial banks themselves, which continue to purchase large quantities of Treasury and mortgage-backed securities each week.
While many believe a balance sheet taper or the eventual end of quantitative easing, should the Fed be able to end the program as anticipated by mid-2022, will lead to a rise in interest rates, it’s unlikely rates will rise. As customer deposits continue to rise and with commercial banks having access to the Fed’s SRP, Treasury yields are likely to remain low and fall just as they have the past two times the Fed tapered its balance sheet.
