The U.S. Treasury is looking ahead to a funding gap of as much as $775 billion beginning in 2016 as Federal Reserve officials debate what to do with a $4.4 trillion portfolio of bonds set to peak later this year.
After years of being one of the biggest buyers of Treasuries, the Fed is on course to stop adding to its portfolio in November. A significant amount of the central bank’s holdings start maturing in 2016, and if the Fed decides not to roll it over into new debt, the Treasury would be forced to borrow an extra $675 billion from the public over a three-year period, according to the Treasury Borrowing Advisory Committee.
Even if the Fed does reinvest, the Treasury would still face having to close a $100 billion funding gap because the budget deficit is projected to start widening again in 2016. The additional supply of debt for sale to private investors if the Fed doesn’t reinvest could put upward pressure on interest rates, economists said.
“Everything seems to be hitting in 2016,” said Stephen Stanley, chief economist at Pierpont Securities. “Depending on what the Fed does, you could either see a modest funding gap that Treasury has to close, or it could be quite large.”
Dennis Lockhart, president of the Atlanta Fed, suggested in July that policymakers would reach a final agreement on their blueprint for exiting years of bond buying at their next meeting in September.
The plan may provide additional details on whether Fed officials will continue reinvesting proceeds from maturing debt after the first increase in short-term interest rates, an event they forecast will occur sometime in 2015.
According to the minutes of the Federal Open Market Committee’s June meeting, “Many participants agreed that ending reinvestments at or after the time of liftoff would be best, with most of these participants preferring to end them after liftoff.”
The Treasury said last week that it will maintain the size of its two-year and three-year note auctions and also keep the amount of longer-term bond issuance unchanged from the previous quarter after reducing two-year and three-year auction sizes by $1 billion a month each from May to July. Its borrowing needs this quarter fell to the lowest level for the period since 2007 as a stronger economy boosts tax revenue.
That will change in 2016 as the deficit widens again, according to Pierpont’s Stanley.
“It just doesn’t seem to me that they are in a huge hurry at this point to cut further, knowing that roughly 18 months from now, they are going to have to reverse course in a pretty significant way,” said Stanley, a former economist at the Richmond Fed.
Given the timing, the Treasury is watching the Fed’s evolving exit plan carefully, said Assistant Secretary for Financial Markets Matthew Rutherford. If the Fed decides to stop reinvesting, “then we will need to adjust accordingly,” he said. “It’s a manageable thing for us, but it is something that we have to watch very closely.”
From November 2011 to December 2012, the Fed sold shorter-dated Treasuries and replaced them with longer-dated ones in a program known as Operation Twist. As a result, little of its holdings mature before 2016.