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So How Much Has the Fed Twisted Up Treasuries?


Minyanville breaks down the Fed's holdings and purchases of Treasuries and assesses the feasibility of extending Operation Twist.

After reading this post from Zerohedge the other day, I started wondering how many long-term bonds the Federal Reserve actually owned, exactly how much of the long end of the yield curve it now held. The goal of Operation Twist is to purchase $400 billion in 6- to 30-year bonds and sell $400 billion in 1- to 3-year bills. [Editor's note: The plan was announced in September 2011, started in October, and is set to end in June 2012. The intent was to lower the yields on long-term bonds while keeping short-term rates stable in order to give consumers and businesses an additional incentive to borrow and spend.]

I've been emailing back and forth with Minyanville reader "BP" and contributor Professor Pinch regarding how the Treasury market may react to changes in the broader market, due to the smaller float, in terms of Treasuries that are available for purchase by the public. A few months back on the Buzz & Banter, I showed a chart of the Treasury holdings of the People's Bank of China, Bank of Japan, and Federal Reserve. Just these three central banks (not including the ECB) own almost 40% of the Treasury market. So does this explain why some moves in the Treasury market are more vicious than others?

To date, the Fed has made $296.14 billion of the $400 billion total Twist purchases.

Here's the breakdown:
6-8 year basket: $95.08 billion
8-10 year basket: $99.21 billion
10-20 year basket: $12.392 billion
25-30 year basket: $84.852 billion

The 25-30 year purchases were the most interesting. The Treasury has issued $97 billion in 30-year debt since Twist began, and with $85 billion (87.47%) in purchases of that sector, that could explain why there has been no bursting of the bond bubble. This spring has been one of the biggest issuance seasons ever in the credit and fixed-income markets ($473 billion in Investment grade new issuance in the US alone), but yields barely moved. Well, this may explain it. Thanks, Ben.

Below is how much the Treasury has auctioned since the Twist began:
7-year notes: $232 billion to date
10-year notes: $153 billion to date
30-year bonds: $97 billion to date

Some other number crunching:
Fed's holding of 25-30 year sector: $160.275 billion of $654.596 billion outstanding (24.49%)
Fed's holdings of 10-25 year sector: $85.633 billion of $282.256 billion outstanding (30.35%)
Fed's holdings of 7-10 year sector: $357.103 billion of $1,144 billion outstanding (31.22%)

(Source: Federal Reserve, US Treasury, Bloomberg)

The other main issue is that the Fed doesn't have much more to sell in the front end. Here's the calculation: The Fed's holdings of the front end (1-3 year) have diminished to $227.04 billion, and if we include the roughly $100 billion left to sell, they don't have much inventory left to sell from the front end. However, if they want to continue the Twist, they can include the 4-5 year bills they hold, numbering about $360 billion.

The biggest problem I see here is that the Fed's balance sheet can really get precarious. Even though the Fed doesn't care if it loses money, because it will just keep buying and buying, you can understand why a number of FOMC members are more than a little wary of adding on more duration risk to the balance sheet. Currently, the average maturity of the Fed's portfolio is 8.16 years (according to Bloomberg) and this will probably migrate towards 9 years by the time Twist is done.

The reason the Fed has no sensitivity to loss with their purchases is that they expect their Treasury holdings to be paid back at par. Theoretically -- and I stress theoretically -- there is no default risk for Treasuries, only credit risk (which doesn't matter if you are holding until maturity). Their holdings of Mortgage Backed Securities (MBSs) are somewhat different, because there is default risk there, although the Fed is not worried about prepayment risk.

So the big question here is, what will the Fed do when Twist ends?

Obviously, given their holdings of short-term Treasury bills, the Fed cannot continue the Twist under the current system. But wait: There is one more factor coming into play that needs to be taken into account. The Fed – by mandate – can only own 33% of a given market at one time. As you can see above, they are fast closing in on that mark in many of the longer-maturity areas. However, if the Fed were to keep up their current pace of purchases over the next few years, they would not eclipse that mark, given that the US runs the same deficit (not ideal, I know, but thinking relative here).

Remember, Twist is essentially inflation neutral. The last thing that Ben Bernanke wants is to go down to Congress and get harangued by Ron Paul again.

Twitter: @MichaelSedacca

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