US Rates: A hidden floater - HSBC

The Fed’s QE Treasury holdings will soon begin to roll out of its portfolio as treasury bonds held by the Fed act like floating rate debt for the budget, so the Treasury is likely to replace them with bills.

Key Quotes

“The Treasury’s budget projections reflect its interest payments to investors and its earnings from the Fed’s System Open Market Account (SOMA) portfolio. The Treasury pays a coupon to the Fed, and then receives the Fed’s earnings (the coupon minus funding costs) from the Fed. Thus, the Fed’s Treasury holdings act like a floating rate (asset swapped) bond from the Treasury’s budgeting perspective.” 

“Many commentators expect the Treasury to react to the Fed’s reduced auction purchases by increasing the size of its publicly auctioned bonds by a similar amount. If our view is correct, it should issue short-duration bills and perhaps notes instead. Therefore, the impact of Fed disinvestment on longer duration bond auctions may be small.”

“The fixed to floating rate mix of Treasury debt has not changed much, based on our measure. The bill share has fallen since 2009, while the Fed’s Treasury holdings increased. To maintain the fixed to floating mix, the Treasury would have to fund all of the Fed’s holdings and half of the deficit with bills in the coming years.”