How fast should the Fed adjust its portfolio? Barclays weighs in

Investing.com -- The Federal Reserve is considering adjustments to its portfolio composition as it moves closer to the end of quantitative tightening (QT).

"Many participants" at the January FOMC meeting expressed support for aligning the Fed’s portfolio with the maturity composition of outstanding Treasury debt.

With the Fed’s weighted average maturity (WAM) currently at nine years—compared to six years for Treasury debt—this shift would require an increased allocation to shorter-term securities.

One key question is how fast the Fed should move. Joseph Abate, a managing director at Barclays (LON:BARC), outlines two possible paths: an accelerated approach and a gradual transition.

“Under the accelerated path, the Fed’s portfolio would reach a representative 22% bill holding share in 2030. It would be purchasing about $250bn/y in bills,” Abate said.

This timeline would significantly shorten the Fed’s portfolio maturity while keeping market disruptions minimal, assuming the Treasury maintains its bill-to-debt ratio.

In contrast, a gradual approach would distribute purchases more evenly across maturities, mirroring the overall debt structure.

"The gradual path would not bring the bill ratio to 22% until after 2045," Abate notes, adding that this would mean annual bill purchases of approximately $125 billion. This slower transition would allow for a smoother adjustment but would take significantly longer to reach the desired composition.

He points out that a shorter portfolio WAM could provide the Fed with greater flexibility in future policy adjustments.

The Fed appears to be favoring a market-neutral portfolio approach with a gradual adjustment that minimizes disruptions.

According to Abate, this measured strategy would take 16 years to reach a market-neutral portfolio, compared to a faster five-year timeline under a bills-only approach. Also, the market-neutral framework had a more limited impact on term premia.

"Because the Fed’s purchases matched the average debt distribution, they did not crowd out front-end supply while pushing the Treasury to issue more term debt,” he explains.

“It also meant that the Fed would not need to maintain a lower fed funds rate to offset the effect of higher term interest rates."

This approach, in turn, provided the Fed with greater "policy space," giving it more flexibility to cut interest rates without quickly approaching the zero lower bound and resorting to additional quantitative easing.