The Composition of U.S. Treasury Holdings in the SOMA
The table below, which shows the current composition of outstanding Treasury debt compared to the composition of the SOMA portfolio, indicates that the Federal Reserve is overweight in longer-duration bonds and underweight in shorter-duration bills and notes.
If we use the optimal portfolio size of ~$5 trillion (and the absence of any Agency holdings) as we did in our prior piece, the Fed will have to buy $1.4 trillion of shorter-duration notes while rolling off $350 billion of longer-duration bonds.
All else equal, the composition change implies a steepening of the curve driven by the Fed’s need for shorter-term instruments to align with the expected structure of the overall Treasury market.
The Timing of Normalization
The Open Market Desk’s January Survey of Market Expectations showed that the median expectation for the end of QT was in June or July of this year. Some FOMC participants noted that timing could be delayed if debt ceiling issues cause large swings in reserves over the coming months, and it may be prudent to consider pausing QT until any debt crisis is resolved to avoid reserves falling below acceptable levels. Hitting the debt ceiling would require the Treasury to spend out of the general account (TGA) and curb bill issuance, essentially injecting reserves into the banking system. Once the crisis is resolved, restarting bill issuance would reverse the effect and cause a potentially rapid decline in liquidity.
While certainly a concern, we believe the Fed will not have to curb QT for a few reasons:
- The Fed did not have to slow the pace of QT during the 2023 debt crisis.
- Single-party control of the executive branch as well as both bodies of Congress make a debt ceiling crisis less likely this year.
- Reserves (as a share of GDP) remain reasonable. While they are not as high as the mid-2010s or post-pandemic, they are higher than they were in 2019 when the Fed did have to pause QT.
Economic shocks coming from trade, immigration or fiscal policy are just as, if not more likely, to cause disruption in the Fed’s QT plans. Our base case is for near-term uncertainty to give way to medium-term growth, allowing the balance sheet normalization process to continue.
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