Is it possible the Fed's QT program is unintentionally working against the Fed's fight against inflation? It might be. Let's do a thread.

First, let's take a step back. Everyone knows that QE suppresses the term premium in longer dated bonds due to the Fed's large purchases. It is thus surprising that QT has not reversed this at all. As shown below, it is still deeply negative and near the lowest in 5 decades.

What gives? We have had 2 years of very elevated inflation, massive budget deficits and yet there has been no change to term premium from the extreme repression period of 2020 and 2021.

Here is where it gets a bit complicated. When the Fed did their massive QE program in 2020 & 2021, approx. 32.5% went to MBS. Mortgage rates in those years were very low, so the Fed was buying MBS with coupons btwn 1-3%.

MBS bonds at issuance have an effective duration of ~7 years. It is shorter than the 30years maturity of a mortgage because borrowers have a prepayment option. Meaning, when rates decline, they have the option to refinance at lower rates.

The Fed stopped buying bonds in November 2021. As they then subsequently started raising rates at the fastest pace in decades, MBS rates starting rising. They are now ~6.3%, so very far from the coupons of the bonds that the Fed bought.

Effectively, this means the prepayment option for borrowers is worth 0. Nobody will prepay their mortgage and enter a new one at much higher rates, so the option to do so is worthless. But that has big implications for the MBS securities.

When the prepayment option is 0, the duration of the MBS bond extends. Essentially, it becomes a 30y bond, which will have an effective duration of 15-20 years. This means the Fed's portfolio has drastically changed its risk profile in the last 12 months.

While the Fed's balance sheet has declined by 4% in notional terms, its effective duration has actually increased substantially. As an example, its effective duration increased by 23% from March 2020 to December 2021, before the hikes began!

Credit to @dampedspring for breaking this down by security below. It is reasonable to estimate that by now, its effective duration has more than doubled. So what does this mean?

It is a stock vs. flow argument. The Fed is not out in the market buying more bonds, so there is no flow that impacts other investors involved in these securities. The Fed always likes to say that its balance sheet policies "work in the background".

If QE and the intent of QT were working in the background, then the increased stock of interest rate risk on the Fed's balance sheet is surely having some unintended consequence as well! The Fed raises the Fed Funds rate with an expectation that it impacts the rest of the curve

But most household and corporate borrowing occurs with maturities between 5-10y in maturity, so what these rates do is far more important. The Fed's duration footprint has grown massively in longer dated bonds at the same time that many other investors are pulling back.

China, Russia, OPEC members are no longer buying, Japan is also not buying (for now), and banks have also reduced their buying. Many investors are actively short bonds, but the Fed's effective ownership of duration is increasing making them are a bigger player in the market now!

This may be complicating their fight against inflation by keeping the much more important 5y and 10y rates too low, which means they might have to increase their policy rate higher than they otherwise need to in order to fight inflation.

What should they do about it? I think they need to be more active in selling Tsys from their balance sheet. If term premiums were to return to 1990-2014 averages, the 10y would be 5.5% instead of 3.5%. If it were to return to the 70s and 80s levels, it would be 6.5%.

I have no doubt that if the 10y were anywhere near those levels, it would be much more impactful in defeating inflation. Below we can chart the 10y vs core inflation (bottom chart). The 10y is near the easiest levels in history relative to inflation.

In conclusion, I think the duration extension of their portfolio has worked against their inflation fight by compressing term premiums and making the yield curve more inverted than it otherwise would be, and this is leading to substantial increase in recession fears.

I don't dismiss the recession concerns at all, but if fighting inflation is the goal, they may need to get much more active with their balance sheet and restore term premiums to more normal levels.

The end (apologies for the obscenely lengthy thread).

10y vs CPI chart that I forgot to add earlier.