The FED and the Balance Sheet: Shrinking the Giant

FED - Cover

Trump’s election and his plan of loose fiscal policy put upward pressure on US inflation. In order to cool down the economy on the verge of full employment, FED raised rates in December and March and has promised two other hikes in 2017. Hiking fed fund rates is not the only approach the FED can pursue for tighter monetary policy. Indeed, the central bank minutes released on April 5, 2017 reported the plan to start shrinking its $4.48 trillion balance sheet in a move toward monetary policy normalization. The scope of this article is to understand how the trimming will take place. Moreover, we attempt to estimate its effects on US Treasury 10-year yields and the yield curve.

FED balance sheet overview

The FED piled up its huge balance sheet in the response of the 2007-08 global financial crisis. As interest rates slashes became ineffective since rates were approaching zero, the FED implemented unconventional monetary policy through three rounds of large-scale asset purchases known as Quantitative Easing (December 2008-March 2010, November 2010-June 2011, September 2012-December 2013). The monetary stimulus expanded FED balance sheet from less than $900 billion before the crisis to $4.48 trillion today. Even though QE ended more than two years ago, FED’s holdings have remained constant over time, as the central bank has rolled over the proceeds from maturing bonds into new purchases. Today, FED’s assets are primarily made up by US Treasury Securities ($2.46 trillion) and Mortgage-Backed Securities ($1.78 trillion)[1].

The main reasons to push for the normalization of the central bank balance sheet are avoiding bond prices distortion provoked by the FED asset purchase programs and creating some policy space for the future, so that in case of a new economic turmoil, the FED at least has the option of doing QE.

grafico 1Chart 1: Co-movement of FED treasuries and S&P 500 (source of chart data: FRED, Yahoo Finance)

Given the fact that the FED is the largest player in the US bond market and it has contributed to fuel the nine-year bull market in stocks, the risk of balance sheet shrinking is a major market selloff, triggered by the tightening. This is what happened with the so-called taper tantrum. The term refers to the 2013 surge in US yields, when the former Federal Reserve Chairman Ben Bernanke announced the start of tapering in their policy of shifting away from QE. In reaction to news, investors panicked and withdrew money from the bond market, resulting in high volatility and falling bond prices.

The central bank fears that moving too aggressively could lead to volatility and so it will be very careful to avoid market disruption. Therefore, policymakers are planning to pause the number of rate hikes as unwinding begins. This is the position taken by the New York Federal Reserve President William Dudley, who considers balance sheet normalization as a substitute for fed funds rate hikes. Moreover, the FED believes that proper signaling and communication will minimize any negative effect on bonds and stocks. Therefore, FED moves will be communicated well in advance, presumably allowing financial markets to absorb the shock.

The shrinking process

Until now, the FED is sticking to its communication policy, announcing the balance sheet reduction two weeks ago, while the date of the actual move (not disclosed yet) is likely to be around the end of 2017. However, there is still a lot of uncertainty concerning how the reduction will actually take place. There are two possible approaches:

  • Selling securities
  • Letting securities mature.

Selling securities is a very aggressive move that would lead to a quick normalization, but also result in interest rates to increase sharply, bringing in unwanted volatility. The alternative consists of simply letting the balance sheet decline by stopping reinvestments. This approach would lead to a slow and soft unwind. Given its predictability, the maturity approach would limit volatility and, thus, it is likely to be the FOMC’s favourite approach to balance sheet shrinking.

In the FOMC March meeting, policymakers discussed two ways of implementing the maturing approach. The first case consists of phasing out reinvestments to let the balance sheet decline at a constant rate. This approach has the advantage of reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee’s policy intentions. The second case would cease reinvestments all at once. This approach is viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.

[Continua a leggere su]

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © apr-17 BSIC | Bocconi Students Investment Club

[1] Federal Reserve balance sheet as of April 13, 2017.