Thu. Jan 20th, 2022

The Federal Reserve has begun sketching plans to shrink the size of its balance sheet, which surfaced during the pandemic when it accumulated government bonds in an effort to stave off an economic collapse.

The US Federal Reserve now holds just under $ 9tn of assets, more than double the amount compared to early 2020 when it launched an unlimited bond-buying program to support markets and reduce long-term borrowing costs for businesses and households that are financially doom. .

Minutes of the Fed’s policy meeting in December, released last week, revealed that policymakers have begun their most comprehensive discussion to date on how they plan to cut the balance sheet size process. management.

The minutes, which also showed that officials thought the Fed might need to raise interest rates “at a faster pace” than originally expected, has since caused sharp movements in financial markets as investors become more focused on the central bank’s sudden pivot after a tighter monetary policy.

This week, real yields – derived from inflation-adjusted treasury bonds – rose to their highest level since June as traders prepared for cuts to the Fed’s balance sheet. Real returns affect every corner of the financial markets, and factor into comparisons that investors use to value assets from stocks and bonds to real estate.

Here’s a guide on how the Fed can manage the process of shrinking its portfolio of securities, and why it matters to markets.

Line chart of assets held by the Federal Reserve ($ tn) showing that the Fed's balance sheet plans have markets on the edge

Why is the Fed now discussing its balance sheet?

Under pressure to responds to rising inflation, the Fed has already announced plans to withdraw the $ 120 billion-per-month bond purchase program it introduced at the start of the pandemic.

The central bank expects to stop buying bonds in March, paving the way for it to start tightening policy by raising interest rates this year. A majority of Fed officials are now recording three quarter-point increases this year, and a further five before the end of 2024.

Shrinking the balance sheet would be another way to limit the amount of stimulus the Fed is pumping into the economy, something officials think it should do given the jump in consumer prices and the strength of the recovery.

“It becomes difficult to justify why the Fed maintains such a large balance sheet when the economy is doing so well,” said Roberto Perli, a former Fed staffer and head of global policy research at Cornerstone Macro.

What are the plans to reduce it?

The Fed has not yet made any final decisions on shrinking its balance sheet, but the December meeting bill showed broad support for a relatively quick cut after the first rate hike.

The process should be faster than the Fed’s previous attempt to withdraw its holdings in 2017, which swelled due to bond purchases following the global financial crisis in 2008.

At the time, the Fed waited for about two years after the first rate hike after the crisis before stopping reinvesting the proceeds of obsolete treasury and agency-backed securities (MBS), a process known as “run-off”.

The Fed believes it can afford to move faster thanks to “a stronger economic outlook, higher inflation and a larger balance sheet”, which contrasts with the relatively lukewarm recovery in the wake of the financial crisis.

Even after the Fed cuts the balance sheet, it is likely to remain much larger than it was before 2008, according to Mark Spindel, chief investment officer at MBB Capital Partners. Spindel said the prospect of cutting it back to its pre-crisis size of less than $ 1tn was a ship that “sailed long”.

Indeed, Fed officials support monthly limits that will limit how quickly runoff can continue to ensure a rate that is “measured and predictable,” according to the minutes. Some also support a faster reduction in the Fed’s holdings of the MBS agency, faster than its stack of treasuries.

At the very least, Fed officials seem to be solely focused on shrinking the balance sheet by not replacing expiring bonds and apparently not directly discussing the sale of assets.

Why are markets on the edge?

Although the Fed announced the end of its bond-buying program and telegraphed impending rate hikes, the sudden discussion of its balance sheet caught investors off guard.

The last time the central bank tried to reduce the size of its balance sheet, it ended revolution as it became clear, too much cash was drained from the financial system.

In 2019, two years after it started winding down its treasury portfolio after the last crisis, short-term financing costs skyrocketed. Banks, which partially filled the gap by buying treasuries, were less willing to lend cash to overnight lending facilities, which further exacerbated the situation.

The Fed was forced to intervene, pump billions of dollars into the so-called repo market and launch a series of monthly asset purchases.

Investors are not worried about a straight repeat of the repo crisis, but when the Fed withdraws stimulus, it could have unintended consequences.

With its unlimited asset buying program, the Fed has left a significant imprint in the $ 22tn US treasury market, the backbone of the global financial system. As it acquired U.S. government debt during the pandemic, it became one of the largest owners of treasury inflation-protected securities, or Tips, which pushed yields deep into negative territory. It now owns more than a fifth of the $ 1.7tn debt alone.

If the Fed starts selling those bonds, it is expected that the supply of Tips in the market will balloon, boosting their returns – known as real returns. This can resonate in every corner of the financial markets, as real returns are used as a marker with which almost every security in the US is priced.

Investors got their first look at it last week, when real yields rose dramatically, leading to a sell-off in speculative technology stocks which is highly sensitive to the tariffs. The move, which accelerated on Monday, weighed further on risky assets, with the technology-heavy Nasdaq entering a technical correction as it has fallen 10 percent from its all-time high.

“The single most important demand for the market in 2022 was the outlook for real returns,” said Deutsche Bank George Saravelos. “It was the ‘glue’ that held the market regime together.”

Line chart of returns on 10-year US Treasury inflation-protected securities (%) showing US real returns rising, causing a sell-off in technology stocks

Could it have an impact on treasury market liquidity?

The primary block to a rapid decline in the balance sheet is the resilience of the treasury market and its ability to function properly when its largest buyer begins to retreat.

Fed officials recently expressed concern, highlighting “vulnerabilities” in the world’s most important bond market and how the weaknesses could affect the rate at which they are retreating.

“Liquidity is not the same as it was 10 years ago,” said Priya Misra, head of US exchange rate strategy at TD Securities.

The Fed has put in place new instruments designed to mitigate potential problems, including a permanent facility that enables eligible market participants to exchange treasuries and other ultra-secure securities for cash at a set rate.

This standing repo facility, unveiled in July, is intended to serve as a setback for the market and avoid a recurrence of the volatility that occurred during the last attempt to shrink the balance sheet.

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