A possible shift in the composition of the Federal Reserve's portfolio of Treasury holdings could result in the central bank buying nearly $2 trillion of bills over the next two years, enough to absorb nearly all of the Treasury's issuance during that period, according to Bank of America Corp.
Strategists Mark Cabana and Katie Craig expect the Fed to adjust its portfolio to better match assets and liabilities in a move that will protect against interest-rate risk and negative equity while bringing down the duration of their liabilities.
It would also end up being a much-needed windfall for the Treasury Department, which has been issuing billions of dollars in short-term debt to fund a growing deficit and replenish its cash balance following last month's increase of the debt ceiling.
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"If you play around with some of the Fed's balance sheet and assume mortgages are reinvested into bills, the balance-sheet goes into bills and they take maturing Treasuries and roll into bills, that's approximately $1 trillion," Cabana, who is head of US interest rates strategy at BofA said in a separate interview. "It's somewhat uncanny that Treasury issues $1 trillion of bills and the Fed buys them. It's a new source of demand at the very front end."
The monetary authority could shift nearly 50% of its assets into Treasury bills to match their short-term liabilities — mainly reserves and reverse repurchase agreements — as well as absorb changes in the Treasury's cash balance, the Bank of America strategists wrote in a note Friday.
They estimate T-bill supply to be $825 billion in fiscal year 2026 and $1.067 trillion in fiscal year 2027, assuming the Department keeps the size of the coupon auctions steady until October 2026.
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Such a move from the Fed would ensure demand for short-term government debt remains robust, easing concerns that massive Treasury issuance would drain market liquidity.
While the Fed is still unwinding its balance sheet — a process known as quantitative tightening — recent rhetoric from policymakers suggests discussions about the portfolio could appear in the minutes of the July Federal Open Market Committee gathering that are set to be released on Aug. 20, the strategists said.
Governor Christopher Waller
Fed officials have left their benchmark interest rate unchanged this year after a series of reductions in late 2024. As a result, total net income from the System Open Market Account
A Dallas Fed working paper that reviewed three types of asset composition, and the pros and cons of each approach concluded that duration matching is effective at reducing income volatility, and a diversified portfolio is more feasible with less concentration risk.
There's a few ways the central bank can quickly grow their bill holdings, according to BofA. The first is reinvesting the maturities and prepayments of mortgage-backed securities, which would amount to $10 billion to $20 billion per month.
Another option is growing reserve balances to offset growth in non-reserve liabilities to keep them stable, which would require about $10 billion to $20 billion per month. The last option would be to reinvest all maturing Treasury coupons into T-bills, which would result in about $20 billion to $60 billion per month in purchases.
It's likely the central bank will begin adjusting their reinvestment strategy immediately after ending its balance-sheet runoff, which Cabana and Craig expect in December 2025 at the latest.
