U.S. Government Bonds Strengthen as Fed Outlines Gradual Portfolio Tapering

By Sam Goldfarb and Katy BurneFeaturesDow Jones Newswires

U.S. government bonds strengthened Wednesday after the Federal Reserve suggested it would likely start reducing its bondholdings later this year in a more cautious manner than some had expected, while laying out early details of a proposed method for tapering the portfolio down.

Nearly all Fed officials at the Fed's May 2-3 meeting agreed that the central bank should start shrinking its $4.5 trillion in Treasury, mortgage bonds and other securities this year, barring any unexpected changes to the economy and its interest-rate policy, according to minutes released Wednesday.

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Fed officials said they are leaning toward an approach that would be gradual, with monthly announced changes to the amount they intend to reinvest back into the bond market from maturing securities. Setting monthly limits, or caps, for how much they can reinvest would reduce the portfolio in a "gradual and predictable manner," they said, reducing the risk of market disruption.

Federal Reserve Bank of Philadelphia President Patrick Harker on Tuesday told an audience in New York he hoped it would be the "policy equivalent of watching paint dry."

Fed officials have previously talked about taking a steady approach to shrinking the portfolio, also known as the central bank's balance sheet.

Still, traders greeted the new details warmly after a long period of anticipation. The yield on the benchmark 10-year Treasury note settled at 2.266%, down from 2.285% Tuesday. Yields fall as prices rise.

Minutes from the Fed's meeting also showed officials thought that it would "soon be appropriate" to raise short-term interest rates again, despite a slowdown in economic growth in the first quarter and some recent softness in inflation. Still, traders appeared mostly focused on the balance sheet plan, said Blake Gwinn, U.S. interest rates strategist at Natwest Markets. Though still preliminary, the plan could lead to an unwinding of the Fed's balance sheet that would be "a little more stretched" out than many analysts had expected, he said.

Others said the Fed needed to provide additional details of its methodology soon to keep markets calm. The balance sheet plans leave "a lot of wiggle room," said Peter Tchir, managing director in strategy at Brean Capital LLC, a securities broker. "I expect they will get us some numbers by the September time frame and they will do everything they can to mitigate any market fears."

The pace of declines in the balance sheet would increase over time under the Fed's leading proposal. The amount of runoff allowed each month would start small and be phased higher every three months, the Fed said in its May minutes. Certain situations could cause the Fed to make adjustments, it added.

Most Fed officials support starting the unwinding sometime this year, something they reiterated in the May minutes and said they planned to continue discussing at their June meeting. The timing of when they release additional details is important because they want to give investors plenty of advanced warning, but also not be tied to specific economic data points or dates.

Federal Reserve Bank of Minneapolis President Neel Kashkari said Tuesday he wanted the central bank to announce more specifics on its balance sheet plans soon. "I want us to put out a detailed plan," he said. "Just to take the uncertainty away and let that go on in the background" while the Fed focuses on the level of short-term interest rates.

Before the financial crisis, the Fed's bond portfolio was just under $900 billion, or 6% of gross domestic product, and consisted mostly of U.S. Treasurys. Buying Treasury and mortgage bonds through three rounds of asset purchase programs was designed to lower long-term rates and juice the economy after the crisis hit. Today, the Fed's balance sheet is around 23% of GDP.

The Fed wants to shrink it again to give itself enough headroom to buy more bonds in another downturn because its benchmark federal-funds rate isn't far enough away from zero to be lowered again much further.

Slowing its reinvestments in the bond market would force the U.S. Treasury to sell more bonds to other buyers, potentially depressing their prices without the Fed standing ready to buy. At the same time, the Treasury could fulfill its borrowing needs by issuing debt of different maturities, making it difficult to project the exact fallout from the central bank's actions, some analysts say.

For now, the Fed is reinvesting proceeds from maturing Treasury and mortgage bonds back into new bonds, keeping the size of its portfolio roughly constant.

Write to Sam Goldfarb at sam.goldfarb@wsj.com and Katy Burne at katy.burne@wsj.com

(END) Dow Jones Newswires

May 24, 2017 17:00 ET (21:00 GMT)