Expanding QE into Treasurys could cause general yield levels to decline by around 25 basis points, which could raise the pace of the Federal Reserve portfolio runoff from $25 to $30 billion per month up to $40-45bn in the short term, according to JPMorgan Securities analysts.

Over the next 12 months, the Fed would be selling nearly $300 billion mortgages and buying Treasurys as they reinvest paydowns, estimated JP Morgan. Bank of America Merrill Lynch estimated approximately $550 billion in Fed portfolio runoff in one year, or half the portfolio, in a down 75 basis point scenario.

"This means that if that rate scenario were achieved and it was determined that the time for tightening had arrived at the end of that year, the Fed would have over $500 billion left to sell into the market,"BofA Merrill analysts said. "Aggressive sales of this amount would likely go a long way to raising mortgage rates sharply and cooling developing inflationary pressures."

They added hat this would give the Fed much greater flexibility in devising an exit strategy from quantitative easing and, by extension , would allow them to tighten aggressively when housing has more permanently stabilized.

However, JPMorgan analysts say the Fed should contemplate expanding its MBS purchases to avoid dislocations within the markets.

Earlier discussion on QE II suggested an unwillingness of certain Fed officials to expand the MBS portfolio and indicated that the Fed was looking to buy Treasurys only. However, market analysts said that purchasing mortgages would help offset accelerated paydowns of MBS in the Fed portfolio if QE drove overall yields lower.

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