Maturity Distribution of SOMA Holdings - RealClearMarkets

October 01, 2014

Economics Group

Thousands

Interest Rate Weekly Notes on the Fed's Exit Strategy, Part II

John E. Silvia, Chief Economist

john.silvia@ (704) 410-3275

Mark Vitner, Senior Economist

mark.vitner@ (704) 410-3277

Michael A. Brown, Economist

michael.a.brown@ (704) 410-3278

In our second installment on the Fed's exit strategy we focus on the timeline behind the normalization of monetary policy, including the latest details of expected FOMC operations to raise interest rates next year.

The Anything But Normal Policy Normalization Timeline

When the Fed begins the process of monetary policy normalization, in our view in June of next year, it will take a number of steps to ensure control over short-term interest rates. First, when the FOMC determines the appropriate time to raise the fed funds target rate, it will use the interest on excess reserves that banks hold at the Fed as the primary mechanism to control short-term interest rates. However, as we have pointed out in Part I of this series, there are concerns given the size of the Fed's balance sheet that there may not be as much control over short-term rates. Thus the Fed introduced the Reverse Repo Facility in order to allow it to effectively pay interest on excess reserves to non-bank institutions, therefore exerting greater control over short-term interest rates since these institutions would not want to lend at a rate below what the Fed would pay them. In addition to describing the use of the Overnight Reverse Repo Facility, the Fed established maximum limits on the reverse repo program to ensure that the facility does not become a destination to invest cash short-term in the event of market unrest.

What the Fed Will Not Do

$4.5 $4.0 $3.5 $3.0

Federal Reserve Balance Sheet

Trillions

Other: Jun @ $217.4B Foreign Swaps: Sep @ $0.0B PDCF & TAF Commercial Paper & Money Market Repos & Dis. Window: Sep @ $0.3B Agencies & MBS: Sep @ $1,748.2B Treasuries: Sep @ $2,447.1B

$2.5

$2.0

$1.5

$1.0

$0.5

$0.0 2007

2008

2009

2010

2011

2012

2013

$3.0 $2.5

Bank Reserves

Trillions

Excess Reserves at Depository Institutions: Sep @ $2.76 T Reserve Balance Requirements: Sep @ $0.08 T

$4.5 $4.0 $3.5 $3.0 $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 2014

$3.0

$2.5

After raising the fed funds target rate, the next issue is how to deal with the

size of the Fed's balance sheet. The Fed's plan indicates that securities $2.0

$2.0

holdings will be reduced by ceasing to reinvest repayments of principal on

the securities held. This phasing out of reinvestments will take place after $1.5

$1.5

the first fed funds rate hike and will be dependent on economic conditions.

$1.0

$1.0

The plans indicated that the Fed does not anticipate selling agency

mortgage-backed securities as part of the normalization process. Thus, the $0.5

$0.5

primary way in which the Fed's balance sheet will be reduced over a

number of years will be through holding these securities to maturity.

$0.0

$0.0

A look at the maturity distribution of the Fed's assets indicates the bulk of

2006 2007 2008 2009 2010 2011 2012 2013 2014

the Fed's Treasury holdings will mature within the next 10 years, while

Maturity Distribution of SOMA Holdings

Total Value of Securities Maturing in Given Year

most of the MBS holdings will not mature until sometime after 2042, $600

$600

prepayment risk aside. This suggests that the size of the balance sheet will

Treasuries: 2044 @ $0.03B

MBS: 2044 @ $107.29B

remain large for quite some time. Furthermore, there are implications for $500

$500

the Fed deciding not to sell MBS, as Richmond Fed President Jeffrey

Lacker pointed out following the announcement. Lacker argues that the $400

$400

Fed's MBS holdings may put downward pressure on mortgage rates, a view $300

$300

we agree with, compared to holding an equivalent amount of Treasury

securities. Thus, mortgage rates would be lower relative to other types of $200

$200

credit. In light of this announcement from the Fed, last week we

downwardly revised our conventional mortgage rate outlook to reflect $100

$100

somewhat lower mortgage rates resulting from the Fed's plan not to sell MBS.

$0

$0

2014 2018 2022 2026 2030 2034 2038 2042

Source: Federal Reserve Bank of New York, Federal Reserve Board and Wells Fargo Securities, LLC

q32014

2014

Quarter End Interest Rates Federal Funds Target Rate 3 Month LIBOR Prime Rate Conventional Mortgage Rate 3 Month Bill 6 Month Bill 1 Year Bill 2 Year Note 5 Year Note 10 Year Note 30 Year Bond

Fo recast as o f: September 26, 2014

Wells Fargo U.S. Interest Rate Forecast

Actual

2014

1Q

2Q

3Q

4Q

Forecast 2015

1Q

2Q

3Q

4Q

0.25 0.23 3.25 4.34 0.05 0.07 0.13 0.44 1.73 2.73 3.56

0.25 0.23 3.25 4.16 0.04 0.07 0.11 0.47 1.62 2.53 3.34

0.25 0.23 3.25 4.18 0.06 0.08 0.13 0.57 1.81 2.59 3.37

0.25 0.36 3.25 4.26 0.21 0.37 0.45 0.86 2.05 2.66 3.48

0.25 0.38 3.25 4.31 0.23 0.54 0.63 0.97 2.16 2.71 3.50

0.50 0.75 3.50 4.39 0.55 0.83 0.92 1.42 2.51 2.84 3.63

0.75 1.00 3.75 4.41 0.89 1.01 1.10 1.48 2.57 2.86 3.66

1.00 1.25 4.00 4.52 1.07 1.19 1.29 2.09 2.75 3.02 3.81

1Q

1.25 1.50 4.25 4.74 1.30 1.40 1.51 2.18 2.98 3.24 3.98

2016

2Q

3Q

1.75 2.00 4.75 4.87 1.80 1.90 2.00 2.41 3.12 3.47 4.12

2.25 2.50 5.25 5.12 2.30 2.42 2.53 2.91 3.59 3.72 4.41

4Q

2.75 3.00 5.75 5.38 2.80 2.92 3.03 3.31 3.96 3.98 4.68

Wells Fargo U.S. Econom ic Forecast and FOMC Central T endency Projections

2014

2015

2016

Change in Real Gross Domestic Product Wells Fargo FOMC

2.1 2.0 to 2.2

2.9 2.6 to 3.0

3.1 2.6 to 2.9

Unemployment Rate Wells Fargo FOMC

5.9

5.5

5.3

5.9 to 6.0 5.4 to 5.6 5.1 to 5.4

PCE Inflation Wells Fargo FOMC

1.7

2.0

2.2

1.5 to 1.7 1.6 to 1.9 1.8 to 2.0

Forecast as of: September 26, 2014 NOTE: Projections of change in real gross domestic product (GDP) and in inf lation are f rom the f ourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation is the percentage rate of change in the price index for personal consumption expenditures (PCE). Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.

Fed Data as of: September 17, 2014

Wells Fargo Securities, LLC Economics Group

Diane Schumaker-Krieg

John E. Silvia, Ph.D. Mark Vitner Jay H. Bryson, Ph.D. Sam Bullard Nick Bennenbroek Eugenio J. Alem?n, Ph.D. Anika R. Khan Azhar Iqbal Tim Quinlan Eric Viloria, CFA Sarah Watt House Michael A. Brown Michael T. Wolf Zachary Griffiths Mackenzie Miller Erik Nelson Alex Moehring Donna LaFleur Cyndi Burris

Global Head of Research, Economics & Strategy Chief Economist Senior Economist Global Economist Senior Economist Currency Strategist Senior Economist Senior Economist Econometrician Economist Currency Strategist Economist Economist Economist Economic Analyst Economic Analyst Economic Analyst Economic Analyst Executive Assistant Senior Admin. Assistant

(704) 410-1801 (212) 214-5070 (704) 410-3275 (704) 410-3277 (704) 410-3274 (704) 410-3280 (212) 214-5636 (704) 410-3273 (704) 410-3271 (704) 410-3270 (704) 410-3283 (212) 214-5637 (704) 410-3282 (704) 410-3278 (704) 410-3286 (704) 410-3284 (704) 410-3358 (704) 410-3267 (704) 410-3247 (704) 410-3279 (704) 410-3272

diane.schumaker@

john.silvia@ mark.vitner@ jay.bryson@ sam.bullard@ nicholas.bennenbroek@ eugenio.j.aleman@ anika.khan@ azhar.iqbal@ tim.quinlan@ eric.viloria@ sarah.house@ michael.a.brown@ michael.t.wolf@ zachary.griffiths@ mackenzie.miller@ erik.f.nelson@ alex.v.moehring@ donna.lafleur@ cyndi.burris@

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