I am continually amused at the extent which a question comes up — let’s say it’s “what happens when the Fed reduces its balance sheet” — it’s answered, and then a few months later, the very same question comes up and everyone (including the people who answered it initially) forgets that we just spilled all kinds of digital ink addressing it.
I mean Jesus: how many times have we talked about the Fed shrinking its balance sheet in the past 12 months. I’d be willing to bet that the number of sell-side notes dedicated to this topic was easily in the hundreds — before March 2017.
Hell, it was just three months ago when we were all talking about balance sheet shrinkage in the context of Donald Trump’s comments about wanting a weaker dollar. Remember that in January? The debate was revived about whether letting assets roll off was preferable in terms of tightening policy in the current environment because it was assumed that going that route would have less of an effect on the dollar than outright FF hikes. That, according to the prevailing narrative, would help appease Trump by not giving the dollar another excuse to rally.
Well fast forward to end-March/early-April and everyone is acting like we didn’t just have this goddamn conversation. Suddenly “Fed balance sheet reduction” is something no one’s ever considered. As if the March Fed Minutes just came out of left field.
And no, this discussion didn’t just suddenly become more relevant because of the hyper focus on 10Y yields. I mean that’s what the whole discussion in January was about, right? “Let’s tighten using the balance sheet so we affect the long-end more than the short-end and if conventional wisdom turns out to be accurate then the result will be more FX-neutral, plus we’ll steepen the curve as an added bonus.”
Also, how many times have we asked “who’s going to buy when the Fed stops reinvesting proceeds?” And I don’t mean “we” as in HR. I mean “we” as in a community of people who talk about markets. The answer is: “well, someone else that’s not the FOMC.” This isn’t rocket science. The long and the short of it (no pun intended) is that suddenly the market is going to have to shoulder the burden of buying what the Treasury is selling at a time when, if we ever get around to fiscal stimulus, there’s probably going to be more supply. Surprise! Could that be a problem? Well, maybe. But likely not. Especially if the Japanese get off their asses and get back on the horse now that hedging costs are lower.
Whatever. Who knows. All we do know is that we’re apparently going to have to have this discussion every day for the foreseeable future. So in an attempt to help readers along in that regard, here’s a fun FAQ sheet from BofAML.
FAQs on the Fed’s balance sheet reduction
How is the Fed thinking about the balance sheet in the setting of policy? The Fed has indicated that they would like to use short term interest rates rather than the balance sheet as their primary policy tool and that they would like the balance sheet run off to be “passive”. Some officials have recently suggested that they might consider taking a pause in any further increase in short-term interest rates as the balance sheet reduction starts, including remarks on Friday from NY Fed President Dudley (Chart 2). Assuming limited impact on financial conditions, we believe the Fed would like to continue raising interest rates as the balance sheet declines.
When will the Fed allow for its portfolio holdings to decline? We expect that the Fed will look to start the process of gradually reducing their balance sheet when the fed funds effective is in the range of 1.25 – 1.5% which should occur later this year. The Fed’s surveys of primary dealers and buy-side market participants also suggest a similar expected rate level for balance sheet reduction. Recent Fed speakers have indicated this process could begin when the fed funds rate is 1-2%.
How will the Fed shrink their balance sheet? The Fed has stated their intention to reduce its securities holdings by simply not rolling over their maturing proceeds in Treasuries and MBS. Although there will be a significant amount of variability in monthly Treasury maturities and agency MBS prepayments, we think the Fed will be content to live with these fluctuations for the sake of message simplicity (Chart 3). The Fed will likely not engage in asset sales as a part of the process.
Will the Fed taper their balance sheet reduction? We expect the Fed will gradually reduce the pace of reinvestments. Tapering would allow the Treasury and agency MBS market time to adjust to the reduced Fed presence. We expect the Fed will gradually phase out their reinvestments over a 12 month period and likely look to reduce the amounts they rollover by 1/12th each month.
What will the market impact be of the Fed normalizing its balance sheet?
Treasury Market: The Fed’s ending of Treasury reinvestments should result in upward pressure on rates via higher term premiums as the market prepares for the eventual balance sheet reduction. Extending prior analysis from the Fed, it is possible that the total impact on 10Y term premium from the duration reduction could be 47 bps over the course of 2018 & 2019 (Table 1). We expect that the 5s-10s curve will likely steepen due to (1) higher term premiums (2) increased mortgage duration (3) modestly flatter OIS curve as the Fed assesses the balance sheet reduction impact.
The ultimate impact on the rates market would be lessened if the Fed were to slow their pace of rate increases or if Treasury were to shorter the tenor of their funding to offset the Fed’s portfolio declines. We expect that Treasury will initially concentrate the majority of their new Fed-related financing at the front end of the curve, i.e. mostly in bills and 2-5Y notes, since short-dated Treasury securities are the closest substitute for bank reserve holdings and could be increased at the lowest cost.
Assuming increased front-end issuance, short-dated swap spreads should tighten and Treasury GC repo rates should rise. The fed funds effective should also move higher in the range and potentially narrow fed funds-LIBOR spreads (Chart 4). Usage of the Fed’s reverse repo facility should decline with increased bill supply & higher front-end rates.