The Federal Reserve has bought trillions of dollars in Treasuries just to fix the bond market. It may need to buy a lot more to help repair the economy.

A surge of new coronavirus cases is clouding the economic outlook in the U.S., and that’s likely to translate into pressure for more action from the Fed — maybe as soon as this month’s meeting. Fed Governor Lael Brainard hinted as much on Tuesday, saying the central bank should pivot its policies toward providing longer-run accommodation.

Wall Street strategists and Fed officials say the focus will now be on sustaining a recovery and potentially keeping a lid on long-term yields as the government pumps in even more fiscal stimulus. The Fed has also been compressing yields with emergency lending facilities supporting everything from muncipal to corporate debt. But those programs are temporary.

“There is a transition that they have to negotiate over the next few meetings from purchasing assets for the avowed intention of market functioning to more traditional large-scale asset purchases” to reduce term premiums and so lower long-term borrowing costs, said William English, former director of the Fed Board’s Division of Monetary Affairs, and now a professor at the Yale School of Management.

In a sign that traders are wary that the Fed could ramp up quantitative easing and buy more long-term debt, the Treasuries yield curve has been flattening in recent weeks. The gap between 5- and 30-year yields has fallen to about 105 basis points, from as high as 129 last month, the peak for 2020.

July Question

The question Fed officials face heading into their July 28-29 meeting is whether they make that shift in combination with changes to guidance on short-term rates. There’s also the issue of whether that would require a conclusion to their strategy review, which has been running for more than a year.

Brainard and other officials suggest the Fed needs to achieve sustainable 2% inflation, a goal that likely means overshooting that target for some time. She along with Chair Jerome Powell also have indicated the Fed is taking a more inclusive approach to its full-employment mandate.

The central bank needs to agree on all of that and roll it into its policy guidance. Minutes from its June gathering said officials want to complete the review “in the near term.”

“Our suspicion is that they don’t feel bound by the time-line of the framework review or the forward guidance,” said Derek Tang, an economist at policy research firm L.H. Meyer in Washington. “They could easily say in July that they are going to announce a new maturity composition of Treasury purchases.”

The Fed already owns $4.2 trillion of U.S. government debt, roughly 22% of the total outstanding. Since slashing rates in March to near zero, it’s purchased about $1.7 trillion in Treasuries with the aim of improving market functioning. It’s still buying about $80 billion a month, one reason 10-year yields, a benchmark for global borrowing, are only about 0.60% and have barely budged since April even as stocks have surged.

Although market functioning has improved markedly since the period of extreme stress in March, Fed officials say uncertainty about the course of the pandemic makes it prudent to maintain the purchases to protect against further shocks.

Stretch It

The Fed’s commitment to keeping its policy rate low for years has left yields with maturities out to five years around or even below the top of its target range for overnight loans. For many strategists, that means the Fed needs to buy long-term debt to have any fresh impact on the economy.

The same holds true if business activity keeps rebounding. In that case, the bet is that Powell would prevent long-term rates from spiking up and crimping the recovery.

“The Fed is very comfortable with having a tremendous footprint in the bond market,” said Ralph Axel, a strategist at Bank of America Corp. “They will want to keep long-term rates low in a good economy as well as in a very bad one.”

The Fed currently is not actively managing the duration of its debt purchases, but is buying a range to roughly match the maturity composition of Treasuries outstanding.

The biggest chunk of its purchases since mid-March have been in maturities up to 2.25 years, with about 33% in that bucket, according to Bloomberg Intelligence’s Angelo Manolatos and Ira Jersey. The second-largest share — about 21% — is in the 2.25- to 4.5-year sector.

Guneet Dhingra, a strategist at Morgan Stanley, has been warning clients that more curve flattening could unfold given growing speculation the Fed will act as soon as this month.

Meanwhile the tool of yield-curve targets, touted by some policy makers in the past as a way to cap yields, has been sidelined for now in a debate over costs and benefits.

Higher yields may seem like a far-off prospect. But the Fed may be eager to keep a lid on them to avoid a sell-off similar to the so-called taper tantrum of 2013, strategists at Societe Generale say. In that episode, the mere suggestion by then-Chairman Ben Bernanke that the Fed could scale back debt purchases wreaked havoc in long-term rates.

“The Fed clearly doesn’t want to live through what happened to markets during the taper tantrum,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. “It may in coming weeks increase the amount of Treasuries it’s buying as a way to ensure yields remain low.”