The taming of the Fed’s balance sheet
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The exact timing of the Federal Reserve’s first interest rate rise is uncertain, but even less clear is what will happen to the $4tn pile of bonds the central bank amassed during the financial crisis.
Optimists take the view that, like a skilled pilot, Fed chairwoman Janet Yellen will be able to bring the size of the balance sheet down smoothly and steadily without hitting too much turbulence.
Pessimists, however, believe the pilot is flying blindly through dense clouds with a faulty radar and constant risk of storms, making the policy normalisation process particularly risky.
“For me the new thing to look out for is what they do to the portfolio,” says Robert Michele, chief investment officer at JPMorgan Asset Management. “We know about moving the [interest rate] corridor. What we should be worried about is what they do with the balance sheet.”
The Fed’s strategy for reducing its bloated balance sheet has evolved over time, but in September policy makers said the Fed will cease or start phasing out reinvestments only after it first begins increasing short-term interest rates. The balance sheet would shrink in a “gradual and predictable manner”, but the details were left unclear — as well as the timing, which will depend on how economic and financial conditions evolve.
One market concern is that allowing assets to roll off automatically as they mature could lead to a jagged path of balance-sheet reduction. BlackRock’s Investment Institute pointed out in a recent report that a third of the Fed’s entire Treasury portfolio, about $785bn, comes due by the end of 2018. Allowing the balance sheet to deflate that quickly could spook markets.
“Letting these bonds run off represents an additional tightening of monetary policy — a dynamic that may well have greater impact on financial markets than the ending of [zero interest rates] in the short run,” the BlackRock report said.
The Treasury’s quarterly meeting with big banks and fund managers that fund the US government also raised this dynamic, with James Clark, deputy assistant secretary for federal finance, estimating that the Treasury would be underfunded by $530bn to $850bn over 2016-2018, if the Fed starts redeeming its portfolio in 2016.
Joseph Abate, a strategist at Barclays, argues that the Fed will therefore most likely “taper” the end of reinvestment, just like it gradually scaled back quantitative easing, to avoid any turmoil.
For example, at one meeting the Fed could promise to reinvest 80 per cent of its repayments and coupons, 60 per cent after the next, and so on until the size of its portfolio gradually shrinks to a more normal level equivalent to the value of currency in circulation — currently about $1.3tn.
Other analysts have argued that the Fed should actively sell off assets anyway in order to shrink its balance sheet more rapidly — a possibility policy makers discussed at their March meeting, at least for bonds maturing soon.
Brian Smedley at Bank of America Merrill Lynch believes a modest and well-signalled $4bn-$5bn a week sale of short-dated Treasuries would smooth the balance sheet shrinkage, reduce the excess liquidity in the banking system that is neutering normal Fed policy tools, and help the money market industry, which is desperate for more short-term US government debt.
If mismanaged, however, this strategy could have a worse effect on bond markets than a simple run-off as securities mature. The Fed itself is clearly hesitant to countenance active sales of assets as part of its efforts to normalise policy.
Ms Yellen this month spoke publicly of the risk of longer-term rates jumping when the central bank finally moves short-term rates up. Asset sales by a central bank sitting on a multi-trillion dollar portfolio would take markets into uncharted and potentially far more nerve-jangling territory.
“Any potential unwinding of the portfolio could have a disruptive impact on markets, unless it’s very gradual and well-telegraphed. If the Fed said it was going to actively sell down its portfolio it would be very bad,” says one senior bond trader.
That said, senior policy makers have said that nothing is ruled out. Last month, Atlanta Fed president Dennis Lockhart told the Financial Times: “I don’t dismiss completely the possibility that we may want to look at selling assets at some stage. I am not one who is dead set against that idea. I just don’t think it is going to be necessary.”
Some argue that the Fed should hang on to the ability to buy and sell a range of assets as part of its long-term toolkit. In a recent paper, Boston Fed economist Michelle Barnes said there could be arguments for the central bank holding on to its “newer balance sheet tools” rather than going back to using only its conventional interest rate lever.
James Caron, a managing director at Morgan Stanley Investment Management, says the Fed’s portfolio could potentially be one of the “knobs they can tweak” to manage monetary policy, but points out that “there are still a lot of question marks” on how it would work in practice.
As the Fed considers its strategy for bringing its balance sheet back down to earth, the odds of turbulence seem high.
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