MARKET INSIGHTS presents the collected perspectives on global markets emerging from our research team and is designed to help our clients make prudent long-term investment decisions.
This quarter, MFS Chief Economist Erik Weisman takes a look at the potential implications of the US Federal Reserve shrinking its balance sheet.
After ballooning for much of the last decade, the US Federal Reserve’s (Fed’s) almost $4.5 trillion balance sheet is expected to begin to shrink late this year or early next. Following its June Federal Open Market Committee (FOMC) meeting, the Fed outlined many of the steps it will take to shed a portion of the securities that had been purchased in order to add liquidity to the banking system in the wake of the global financial crisis. The central bank bought trillions of dollars of US Treasury and mortgage-backed securities (MBS) beginning in late 2008 subsequent to pushing short-term interest rates to their zero lower bound. By flooding the banking system with reserves — the money the Fed “printed” in order to buy bonds — the central bank hoped to stabilize the economy, lift asset prices and ultimately avoid deflation.
Given how highly correlated quantitative easing by the Fed and other central banks (such as the European Central Bank, the Bank of Japan and the Bank of England) has been with lifting asset prices, investors might wonder what the impacts will be of reversing these unconventional policies. The Fed’s goal is to engineer a slow and predictable — and limited — decline in its securities holdings that won’t disrupt financial markets.
Central banks have never had to unwind anything approaching the scale of the Fed’s post-crisis interventions. Let’s think about what questions investors should be asking themselves as we look ahead to the beginning of the run-off.
What we know
At her quarterly press conference in June, Fed chair Janet Yellen indicated that the run-off of Treasuries and MBS could begin relatively soon, though there is a debate as to whether the Fed will announce its intentions at its September meeting or at its December meeting. Most observers expect the unwind to last between three and five years.
At the outset, the Fed announced that the roll-offs will have monthly caps of $6 billion in maturities in Treasuries, with the cap increasing by $6 billion each quarter until it reaches $30 billion per month. The MBS roll-offs will be initiated with an initial cap roll-off of $4 billion per month, with the cap increasing by $4 billion quarterly until it reaches $20 billion per month.
What we don’t know
How will the Fed handle “lumpy” maturities?
The Fed’s goal is to put roll-off caps in place and let them run quietly in the background. Unfortunately, once they begin to rise, there will be many months when the caps are higher than the maturities for that month. For example, the cap for Treasuries maxes out at $30 billion per month, but there are months where perhaps only $10 billion in holdings mature. So while in theory $50 billion of both Treasuries and MBS could roll off in any one month, in practice the amounts will be smaller in many months, sometimes considerably smaller. Consequently, the runoff will take place in fits and starts. For instance, in August 2019, $70 billion in Treasuries will mature. The Fed will have to reinvest the $40 billion balance over the cap. This raises question of where the Fed will reinvest the rebalances and what impacts those reinvestments will have on the yield curve.
What will the terminal size of the balance sheet be?
The Fed’s balance sheet was less than $900 billion in the run-up to the financial crisis and has stabilized at close to $4.5 trillion in recent years. To date, the central bank has not specifically communicated to the market the desired or anticipated terminal size of its balance sheet or how long it might take to get there. Thus far, the Fed has said only that the FOMC “currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future.” While there’s debate over the ultimate size of the balance sheet, many economists suggest that the final figure will land somewhere between a still very sizable $2.5 trillion and $3.5 trillion. Obviously, the higher the terminal level, the less disruptive the run-off should be.
Investors must also grapple with what impact the shrinking balance sheet will have on the Fed’s primary policy tool, the federal funds rate. For the past several years, Fed policymakers have used their “dots” to project where they forecast the fed funds rate to be at the end of each of the next three years and over the longer term. To date, members of the FOMC have not lowered their fed funds rate forecast in response to the recent discussion over when to begin the process of shrinking the balance sheet. Indeed, the minutes of the committee’s June meeting show that policymakers are split over the cumulative effects of the impact of the balance sheet roll-off on interest rates. Several indicated that shrinking the balance sheet would — all else being equal — flatten the rate-hike path relative to what it would have been if the balance sheet remained constant. Other participants did not think the roll-off would play a large part in rate decisions. We tend to side with those who see a flatter rate path and a lower terminal rate, given that building up the balance sheet effectively lowered interest rates when policy rates were constrained by the zero lower bound. It seems logical that reducing the size of the balance sheet should therefore reduce the need for future rate hikes to some degree. Stated another way, if the balance sheet were to decline by $1 trillion, one would think this tightening of liquidity would substitute for rate hikes, even if only to a small degree. Notably, the Fed has been eager to stress that it’s the stock of the quantitative easing that has eased liquidity. Thus partially reversing this process should tighten liquidity somewhat and substitute for some of the tightening carried out through policy rate increases.
How will the US Treasury react?
As the Fed reduces its reinvestment of the proceeds of maturing holdings, the US Department of the Treasury will need to find private-sector buyers for the debt that the Fed had been rolling over. At what points along the yield curve the Treasury decides to issue will be of great interest to investors. Should the Treasury focus issuance on bills at the short end of the curve, the disruption will likely be minimal, given the robust demand for high-quality, short-maturity paper. But if the Treasury moves further out the curve, the impact could be more dramatic, particularly if this were to coincide with a decision to issue ultra-long maturities of 50 years or more, as has been floated by Secretary Mnuchin. Issuing longer-dated bonds could tighten financial conditions substantially by selling considerably more bond duration to the market.
Keep in mind that the Treasury’s future issuance will not only have to take into account the Fed’s balance sheet shift, but may also need to factor in any additional issuance stemming from fiscal stimulus, should the Trump administration’s policy proposals get back on track.
How will the market react?
A recent Fed study estimated that the cumulative $3.6 trillion quantitative easing program lowered long-term interest rates by about 85 basis points. 1 Assuming the Fed trims the balance sheet by approximately $1.5 trillion, and that quantitative easing and quantitative tightening are reasonably symmetric in their effect on treasury yields (which may or may not be the case), you could surmise that all things being equal, long-term rates will react by rising around 35 basis points in the coming years.
Financial markets have thus far taken the prospect of a shrinking balance sheet in stride. But as we’re often told, past performance is no guarantee of future results. The Fed is setting sail into uncharted waters, so overconfidence that the markets will continue to react to the shift in muted fashion is to be discouraged. Since longer-term rates are historically very low, the process of unwinding the balance sheet and removing liquidity from the system could apply some upward pressure on rates. However, the long-term outlook for both growth and inflation remains weak. The US and global economies continue to be buffeted by a variety of headwinds, including extraordinarily high levels of debt, unfavorable demographics and the disinflationary effects of globalization and technological advances. Consequently, we maintain the view that going forward long rates will likely be contained in a low range relative to their history.
1 Bonis, Brian, Jane Ihrig and Min Wei (2017). “The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 20, 2017, https://doi. org/10.17016/2380-7172.1977.
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