Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How The Federal Reserve Quietly Bought The Bond Market
Transcript
- Lucas: If you look at the Federal Reserve’s balance sheet right now, it sits at roughly eight point one trillion dollars. That is not just a number; that is the central bank owning nearly a third of all outstanding US Treasury debt and a massive chunk of the mortgage market. Luna: It feels less like a temporary emergency measure anymore and more like the new normal for how we finance government spending. Lucas: Exactly. When they started quantitative easing in two thousand and eight, the goal was to push long-term yields down to stimulate borrowing. But today, the Fed holds assets that were supposed to be sold off years ago. The question isn't whether they can unwind this safely—it's whether they even want to try. Luna: So is this about controlling interest rates, or is it about preventing a liquidity crunch in the bond market? Lucas: It’s both, but let’s be precise about the mechanism. The Fed doesn’t just buy bonds; it creates reserves out of thin air to pay for them. When they hold these securities, they are effectively suppressing the term premium—the extra yield investors demand for locking up their money for ten or twenty years. Luna: That sounds like they’re artificially capping the cost of borrowing for the government. Lucas: Precisely. By holding such a large share of the market, the Fed reduces the supply of bonds available to private investors. With fewer bonds chasing the same amount of cash, prices stay high and yields stay low. It works until it doesn’t, which brings us to the current dilemma facing the markets in September of two thousand and twenty-six. Luna: And what does the current dilemma look like on the ground for regular investors? Lucas: For pension funds and insurance companies, it looks like distorted pricing. They’ve been forced into riskier assets because safe government bonds don’t offer enough return. If the Fed suddenly stops rolling over maturing debt, the sudden drop in demand could send yields spiking overnight. Luna: So the risk isn’t just higher rates, it’s a violent repricing event. Lucas: Yes. And here is the concrete detail most people miss: the maturity structure. The Fed holds a lot of short-term bills, but they also hold hundreds of billions in long-term notes. When those long-term notes mature, the Fed has to decide whether to reinvest them or let them roll off their books. Reinvesting keeps the status quo. Letting them roll off shrinks the balance sheet and pushes yields up. Luna: Doesn’t shrinking the balance sheet sound like good fiscal discipline? Like paying down the tab? Lucas: On paper, yes. In practice, it’s dangerous if done too fast. Think about the last time they tried quantitative tightening in two thousand and nineteen. They barely started reducing holdings before the repo market froze up. Banks couldn’t lend to each other overnight because there wasn’t enough cash in the system. Luna: So they had to hit the brakes almost immediately to prevent a credit freeze. Lucas: Right. They reversed course within weeks. That incident proved that the financial system is now addicted to Fed liquidity. Removing it too quickly causes friction. Today, with banks still adjusting to post-pandemic deposit flows, that risk is even higher. Luna: It seems like the Fed is trapped between fighting inflation and protecting market stability. Lucas: That is the exact trap. If they keep buying bonds to suppress yields, they fuel inflation. If they stop buying and let yields rise, they risk crashing the housing market and stressing bank balance sheets. It’s a no-win scenario unless growth accelerates significantly. Luna: Do private investors actually have much say in this anymore, or is the Fed the only game in town? Lucas: Private participation has dropped. During the peak of quantitative easing, foreign central banks and domestic institutions bought trillions. Now, a huge portion of new issuance is absorbed directly by the Fed or held by households looking for safety. The market depth is shallower than it used to be. Luna: Shallower markets mean bigger price swings. Even small changes in demand cause big moves in yield. Lucas: Correct. And this leads to something called fiscal dominance. When the government owes so much money, and the central bank holds so much of that debt, monetary policy becomes subservient to fiscal needs. The Fed can’t raise rates high enough to crush inflation without causing a sovereign debt crisis. Luna: That sounds like a loss of independence for the central bank. Lucas: It is. Independence is theoretical when your balance sheet is tied to the solvency of the treasury. The Fed wants to control inflation, but the treasury needs cheap financing to service the national debt. Those two goals often conflict. Luna: So where does that leave the average saver trying to protect their wealth? Lucas: It leaves you exposed to real yield erosion. Nominal interest rates might look decent, but if inflation stays sticky due to structural factors, your purchasing power is still declining. You’re essentially lending to the government at a negative real rate through low-yielding savings accounts. Luna: Which pushes people toward speculative assets like crypto or private equity, hoping for higher returns elsewhere. Lucas: Exactly. That is the unintended consequence of keeping rates artificially low for too long. Capital gets misallocated into bubbles because safe assets don’t pay enough. It’s a classic sign of a distorted financial system. Luna: Is there any precedent for this? Has any other country dealt with a central bank owning this much debt? Lucas: Japan is the closest comparison. The Bank of Japan owns over half of all Japanese government bonds. They’ve kept rates near zero for decades. It hasn’t collapsed, but it has created a stagnant economy with very little monetary policy room to maneuver. Luna: So we might be looking at a prolonged period of low growth and low volatility, punctuated by occasional shocks. Lucas: That’s a fair assessment. Volatility is compressed until it isn’t. The longer the Fed delays unwinding its position, the harder the eventual adjustment will be. Markets hate uncertainty, and right now, the path forward is incredibly unclear. Luna: It makes me wonder if we should stop watching the Fed entirely and focus on real economic indicators instead. Lucas: You should watch both. The Fed controls the price of money, but the real economy determines whether that money is useful. Right now, the disconnect is widening. Financial conditions remain loose while consumer sentiment remains weak. Luna: That disconnect is usually a precursor to a correction. Lucas: Historically, yes. But corrections take time to work through the system. We might be in the long, slow grind phase rather than a sudden crash. Luna: Before we go deeper into the sector impacts, I want to pause for a moment. If walking through the economy with us has made something click, consider supporting the show directly. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that is literally what funds making this many of these episodes possible. No ads, no corporate sponsors, just listener support keeping the research rigorous. Lucas: It really does make a difference. It allows us to dig into the data without worrying about advertiser approval. Thanks to everyone who contributes. Luna: Back to the bond market—let’s talk about the housing angle. How does all this Fed activity actually touch my mortgage rate? Lucas: Directly. The Fed buys mortgage-backed securities. When they do, they drive up the price of those securities, which lowers the yield. Lenders then pass those lower yields on to homebuyers in the form of lower mortgage rates. Luna: So the Fed is essentially subsidizing homeownership by keeping rates down. Lucas: They certainly acted like it during the pandemic. But now, as they reduce those holdings, mortgage rates tend to drift upward independently of the federal funds rate. That is why you see mortgage rates staying high even when the Fed signals a cut. Luna: It decouples housing from the broader interest rate cycle. Lucas: Exactly. Housing becomes its own beast. And that matters because housing is such a huge part of household wealth. If rates stay elevated, home prices soften, and consumers feel poorer. That slows down the entire economy. Luna: So the Fed is accidentally throttling consumption by keeping housing costs high. Lucas: That is a very accurate way to put it. They are trying to cool inflation, but they are using a sledgehammer that hits housing hard. There is no fine-tuning knob here. Luna: Does this mean we should expect the Fed to pivot back to buying bonds soon? Lucas: A full return to quantitative easing is unlikely. Politically, it’s toxic. But a slowdown in the pace of balance sheet reduction? That is already happening. They are letting bonds roll off faster than they replace them, but the net decline is slowing down. Luna: It sounds like a managed decline rather than a strategic withdrawal. Lucas: Managed decline is the best case scenario. The worst case is an uncontrolled unraveling where the market loses faith in the Fed’s ability to manage the exit. Luna: What would trigger that loss of faith? Lucas: Usually, it’s a combination of stubborn inflation and a spike in unemployment. If inflation refuses to budge while the economy slows, the Fed looks incompetent. Competence is everything for central banks. Luna: So credibility is their most valuable asset, and it’s fragile. Lucas: It is. Once credibility is gone, expectations change. Workers demand higher wages, businesses raise prices preemptively, and inflation becomes entrenched. It is very hard to reverse once that happens. Luna: Given all this, what is the one thing listeners should keep an eye on to gauge where things are heading? Lucas: Watch the ten-year Treasury yield. Ignore the daily noise. Watch the trend. If it starts drifting persistently above five percent, that is a signal that the market believes the Fed is losing control or that inflation is structurally higher than expected. Luna: Five percent is the psychological barrier, right? Lucas: It is. It breaks a lot of models that were built on the assumption of sub-three-percent rates. Above five, the calculus for every business investment changes. It’s a regime shift. Luna: So we are standing on the edge of a new regime, waiting to see which direction we fall. Lucas: We are. And the Fed is holding the ladder, hoping no one slips. Luna: Will the ladder hold? Lucas: Only if they navigate the next six months with extreme care. One wrong move, and the whole structure rattles.