The Federal Reserve has started outlining plans to shrink its balance sheet, which it inflated during the pandemic as it sucked up government bonds to avert an economic collapse.
The US Federal Reserve now holds nearly $ 9 trillion in assets, more than double what it did in early 2020 when it launched an unlimited bond purchase program to prop up markets and lower long-term borrowing costs for businesses and households that face financial ruin.
The minutes of the Fed’s December meeting released last week show that policy makers have begun their most comprehensive discussion yet on how to handle the process of trimming the total assets.
The minutes, which also showed that officials believed the Fed might need to hike rates “faster” than originally expected, has since sparked sharp swings in financial markets as investors become more sensitive to the central bank’s abrupt shift to tighter monetary policy are set politics.
This week, real yields – derived from inflation-adjusted government bonds – rose to their highest level since June as traders prepared to cut the Fed’s balance sheet. Real returns affect every corner of the financial markets and feed into the equations investors use to value assets from stocks and bonds to real estate.
Here’s a guide on how the Fed might handle the process of reducing its securities portfolio and why it matters to the markets.
Why is the Fed discussing its balance sheet now?
Under pressure to respond to rising inflation, the Fed had already announced plans to withdraw the $ 120 billion monthly bond purchase program launched at the beginning of the pandemic.
The central bank expects to stop buying bonds in March, paving the way for policy tightening through rate hikes this year. A majority of Fed officials are now planning a three-quarter point increase this year and another five by the end of 2024.
Downsizing the balance sheet would be another way of curbing stimulus pumped into the economy by the Fed, which officials believe is necessary given the surge in consumer prices and the strength of the recovery.
“It’s getting harder and harder to justify why the Fed has such a big record when the economy is doing so well,” said Roberto Perli, former Fed official and head of global policy research at Cornerstone Macro.
What are the reduction plans?
The Fed has not yet taken any final decisions on cutting its balance sheet, but the report from the December meeting showed that there was broad support for a relatively quick cut after the first rate hike.
The process should be faster than the Fed’s previous attempt to run down its holdings in 2017, which had swelled due to bond purchases following the global financial crisis in 2008.
Back then, the Fed waited about two years after the first post-crisis rate hike before stopping reinvesting the proceeds of maturing US Treasuries and Agency Mortgage Backed Securities (MBS), a process known as run-off.
The Fed believes it can afford to act faster thanks to “a stronger economic outlook, higher inflation and bigger balance sheet”, in contrast to the relatively mild recovery from the financial crisis.
Even after a balance sheet cut by the Fed, it should remain significantly larger than before 2008, according to Mark Spindel, Chief Investment Officer at MBB Capital Partners. Spindel said the prospect of hacking it back to its pre-crisis size of less than $ 1 trillion is a ship that has “sailed long”.
In fact, Fed officials are advocating monthly caps that would limit how fast settlement can occur to ensure a “measured and predictable” pace, the minutes say. Some also advocate reducing the Fed’s holdings of MBS agencies faster than their stacks of government bonds.
For now, at least, Fed officials appear to be focused solely on shrinking the balance sheet by not replacing maturing bonds and apparently not discussing direct asset sales.
Why are the markets on the edge?
Although the Fed had announced the end of its bond purchase program and telegraphed impending rate hikes, the sudden discussion about its balance sheet surprised investors.
The last time the central bank tried to reduce its balance sheet total, it ended in upheaval when it became clear that too much cash was being withdrawn from the financial system.
In 2019, two years after starting to wind down its treasury portfolio after the last crisis, short-term funding costs skyrocketed. Banks, which had partially closed the gap by buying government bonds, were less willing to lend cash for overnight loans, which exacerbated the situation.
The Fed was forced to step in by pumping billions of dollars into what is known as the repo market and embarking on a series of monthly security purchases.
Investors are not worried about a repeat of the repo crisis, but if the Fed pulls back on incentives, it could have unintended consequences.
With its unlimited asset purchase program, the Fed has had a significant impact on the US $ 22 trillion Treasury bond market, the backbone of the global financial system. When it bought US Treasuries during the pandemic, it became one of the largest owners of inflation-linked treasury stocks or tips, which pushed returns deep into negative territory. It now owns more than a fifth of its $ 1.7 trillion debt alone.
When the Fed starts selling these bonds, the supply of tips in the market is likely to spike, driving up their yields – called real yields. That could reverberate in every corner of the financial markets as real returns are used as a marker for almost every security in the US.
Investors got their first glimpse of this last week when real yields rose dramatically, triggering a sell-off of speculative technology stocks, which are highly rate sensitive. The move, which accelerated Monday, continued to weigh on risky assets as the tech-heavy Nasdaq slid into a technical correction as it fell 10 percent from its all-time high.
“The most important question for the market in 2022 was the outlook for real returns,” said George Saravelos of Deutsche Bank. “It was the ‘glue’ that held the market organization together.”
Could this have an impact on the liquidity of the treasury market?
The main obstacle to a quick reduction in total assets is the resilience of the treasury market and its ability to function properly when its biggest buyer pulls out.
Fed officials recently expressed concern, pointing to “weaknesses” in the world’s major bond market and how the weaknesses could affect the pace of its retreat.
“Liquidity is no longer the same as it was 10 years ago,” said Priya Misra, head of US interest rate strategy at TD Securities.
The Fed has introduced new tools to mitigate potential problems, including a permanent facility that allows eligible market participants to exchange government bonds and other highly secure securities for cash at a set rate.
Introduced in July, this standing repo facility is designed to act as a backstop to the market and avoid recurrence of volatility in the last attempt to reduce the balance sheet.