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Even after liftoff, Fed is still the elephant in the bond market

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The Federal Reserve is expected to raise US interest rates next week - but that doesn't mean it's disappearing from the bond market, and its ongoing presence there should hold down mortgage rates and corporate borrowing costs for years.

[NEW YORK] The Federal Reserve is expected to raise US interest rates next week - but that doesn't mean it's disappearing from the bond market, and its ongoing presence there should hold down mortgage rates and corporate borrowing costs for years.

The Fed meets next Wednesday and Thursday. While it will begin to raise rates, it has signaled it will maintain its balance sheet, which includes US$2.5 trillion in US government debt as a way of ensuring it has ample cash to support the economy.

More than US$200 billion worth of Treasuries in the Fed's portfolio are maturing in 2016, but the central bank is expected to reinvest those proceeds, rather than let them mature and roll off. It will likely wield considerable influence on longer-term Treasuries yields, mitigating negative effects from the rise in short-term rates, analysts and investors said.

Another US$1.1 trillion in Treasuries will mature through 2020. "With the reinvestment process in the market, it will cap rates. It won't drive them down, but it would prevent them from rising too quickly," said Gemma Wright-Casparius, senior portfolio manager at Vanguard, the largest US mutual fund company in Malvern, Pennsylvania, with over US$3 trillion in assets.

The Fed's vast holdings stem from three rounds of bond purchases, or quantitative easing, which expanded its Treasuries ownership fivefold from the end of 2008.

The Fed's purchases will come at a time when the federal government has hinted it may scale back its longer-term borrowing in 2016. A Reuters poll on Dec. 4 showed brokerages that deal directly with the Fed generally do not expect the central bank to start cutting its balance sheet for at least 12 months. "Sources of demand including Fed reinvestments along with net issuance declining would keep long-end yields contained,"said Gene Tanuzzo, portfolio manager at Columbia Threadneedle in Minneapolis, which has US$471 billion in assets.

While the pace of the Fed rate rises is still up in the air, the benchmark 10-year Treasuries yield will likely firm to 2.50 per cent by the end of 2016, according to fund managers interviewed. If the Fed were not to reinvest in Treasuries, analysts projected the 10-year yield would shoot up to 3 per cent.

On Friday, the 10-year yield was at 2.17 per cent.

AUCTION "ADD-ONS"

Investors anticipate the Fed will share its plans on replenishing its Treasuries holdings at the end of its Dec. 15-16 meeting, when it is expected to raise short-term rates. "The Fed would want to do it with minimal market impact," said John Bellows, portfolio manager at Western Asset Management Co. in Pasadena, California, which has US$446 billion in assets."They need to do it earlier rather than later." In the minutes of the July FOMC meeting, most Fed policy-makers "thought that it might be best either to wind down reinvestments or to manage them in a manner that would smooth the decline in the balance sheet in a predictable way." Fund managers expect the Fed will request the US Treasury to issue more debt for its holdings in the form of "add-ons" at the Treasury's monthly auctions, which are additional sales of debt only made to the Fed.

Auction "add-ons" are seen as the least disruptive to the bond market because the central bank is not competing with private investors for supply.

The Treasury currently holds six auctions on coupon-bearing Treasuries issues each month, in addition to a sale of Treasury Inflation-Protected Securities.

The central bank might also consider conducting open market operations like it did during "Operation Twist" where it announced what type of longer-term Treasuries it would like to buy.

Investors remain somewhat cautious on whether the Fed will achieve its goal of holding down long-term rates through its Treasuries reinvestment. "There are still unknowns how this will work," said Michael Arone, chief investment strategist at State Street Global Advisors' US Intermediary Business in Boston, which has US$2.4 trillion in assets. "This is contributing to the Fed's desire to move at a very slow pace."

REUTERS