Bond traders are expecting Fed to respond to another important question

The U.S. Federal Reserve is gathering for a meeting on October 27-28. With U.S. monetary policy-makers making little progress on their way to increasing rates, they’re also postponing resolving how they approach the $215 billion of Treasuries ready to mature and roll off the Fed’s balance sheet next year, and almost $800 billion through 2018.

This is spurring indecision over a less-popular issue for the Fed - how it is planning to reinvest proceeds from holdings of gov bonds accumulated since the financial crisis. Another question is if it may do so in a way that addresses higher bond-market volatility, Bloomberg news agency says.

Hopes for the removal of policy accommodation by means of higher interest rates have aggravated a decline in liquidity in the market for U.S. government debt.

Aaron Kohli, a fixed-income strategist at Bank of Montreal, says that in order to hamper it, the Fed could restock its Treasury portfolio by obtaining older securities in the secondary market, rather than its customary method of buying new issues directly from the Treasury.

"One approach benefits market liquidity in the short-term, the other doesn’t," Kohli said adding that if volatility is pressured, the market can become a lot easier to trade in the near term.

"They’ve talked a lot more about Treasury-market liquidity and they’ve spent a lot of time investigating it."

Very few in the market stick to an opinion that the Fed will simply stop reinvesting, since such a decision would force the Treasury to sell more debt into the open market. Purchasing bonds in the secondary market could help the Fed offset rising volatility by stepping into a function traditionally filled by banks, as many retreat from market-making roles amid tougher regulations.

The Fed’s balance sheet includes $2.46 trillion of Treasuries, up from about $800 billion before policy makers began taking extraordinary steps in 2007 to bolster the banking system under the stress of a decline in the housing market.

Some say officials could shift their reinvestment strategy if they were worried about the state of the economy, however, they would somehow signal their intentions before any implementation.

While the Fed must address the topic of balance-sheet management at some point, mounting uncertainty about its policy intentions remains the Fed’s most pressing priority, says Thomas Simons, a money-market economist at Jefferies Group LLC in New York, a primary dealer.

“There’s a significant difference of opinion in how to interpret what they’re doing,” Simons said. “That’s a problem they need to solve immediately.”

As for increasing rates, futures traders are assigning only a 6 percent probability that the Fed will increase rates at its Oct. 27-28 meeting, says Bloomberg, noting that the first month where the market sees the Fed lifting off is March, with a 60 percent likelihood.

Meanwhile, the Financial Times has reported that almost two-thirds of influential financial institutions consider the lift-off will happen before the 2015 is over.