The reaction of the financial markets to the Fed's emerging balance-sheet strategy so far has been muted, boosting policy makers' hopes that the drawdown can go off without much trouble. Most FOMC participants in March envisaged that the central bank would begin the process of reducing its holdings of Treasury and mortgage-backed securities later this year, according to the minutes of that meeting.

Fed officials maintain that forward-looking investors have already taken the coming decline into account so that the market's reaction to its actual start should be limited.

Still, some Fed watchers argue that the Treasury Department will have a greater say than the Fed in determining the impact of a reduction in the central bank's $2.5 trillion portfolio of U.S. government securities. That's because the department has to decide how to make up for the financing it will lose when the Fed begins to allow bonds to roll off as they mature rather than reinvesting the proceeds.

And so far it's not clear what Treasury will do, although some clues may surface this week.

Investors may get some insight into the Treasury's plans when the department announces on May 3 the size of its quarterly bond and note auctions — the so-called refunding announcement in which shifts in debt-management plans are often telegraphed. Treasury Secretary Steven Mnuchin has raised the possibility of the U.S. issuing 50-year or longer-dated bonds to take advantage of low interest rates.

A possible fourth-quarter launch of a 50-year bond to coincide with a reduction in the Fed's balance sheet might make sense, according to Gemma Wright-Casparius, who makes trading decisions for more than $60 billion in U.S. government debt portfolios at Vanguard Group Inc. It's “a good time to kind of marry the two together,” she said.

If the government issues more bills, it would effectively be a “freebie” for the financial markets and the economy, according to Lou Crandall, chief economist at Wrightson ICAP. Short-term interest rates would remain anchored by the Fed and so wouldn't be much affected by the added supply of bills.

But if the Treasury opts to issue more longer-dated securities instead, that would put upward pressure on Treasury and corporate bond yields and mortgage rates, with implications for the housing market and the broader economy.

“A lot depends on how the Treasury reacts,” Fed vice chairman Stanley Fischer acknowledged in an April 17 appearance at Columbia University in New York, adding, “I don't know what they will do.”

Fischer argued though that any Treasury move wouldn't be a big problem for the Fed because the central bank could adjust what it's doing with the federal funds rate in response to what happens in the financial markets.

Complicating the Fed's task is its desire to sharply reduce its holdings of $1.8 trillion in mortgage-backed securities. Many participants at the FOMC's March meeting stressed that the reduction in the balance sheet “should be conducted in a passive and predictable manner,” according to the minutes. Yet that's not possible when it comes to mortgage-backed debt, Pimco's Clarida said.

Mortgage Securities

Such securities can unexpectedly come due early if homeowners decide to move or to refinance their mortgages. So if the Fed wants its drawdown to be predictable, it will have to actively manage its holdings and not just passively accept what happens in the market.

“Some of their goals are potentially in conflict,” agreed Mike Fratantoni, chief economist at the Mortgage Bankers Association.

He worries about volatility in the market in the coming months as Fed policy makers debate their balance sheet plans.

Once the rundown begins, Fratantoni sees the 30-year fixed mortgage rate rising to more than 5% next year, from 4.2% now. The spread between that rate and the 10-year Treasury yield will likely widen by 10 to 20 basis points from about 180 basis points currently, he added.

While the Fed has made clear its desire to rid itself of much of its mortgage-backed debt, it's not been so forthcoming on how far it wants to reduce its asset holdings overall. Yellen told lawmakers on Feb. 14 that she foresaw a “substantially smaller” balance sheet, though she also said, “I can't put a number on that.”

Her predecessor, Ben Bernanke, told CNBC television Monday that he thinks the Fed will aim for a balance sheet totaling $2.3 to $2.8 trillion.

Whether the drawdown goes smoothly or not, the eventual size of the balance sheet will be partly determined by global demand for cash, which is outside the Fed's control. It will also be affected by how much reserves commercial banks want to hold, said former Fed official Eric Swanson.

“It's nice for the Fed to be clear, but in this case they can't be,” said Swanson, now a professor at the University of California, Irvine.

Bloomberg News

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