After raising U.S. interest rates four times since the end of 2015, the Federal Reserve (Fed) is ready to undertake the next phase of monetary policy “normalisation”: a reduction in the size of its balance sheet, known as balance sheet run-off. Despite some investor concern about the anticipated reduction in central bank holdings of government bonds and mortgage-backed securities (MBS), we expect that the run-off is unlikely to disrupt markets, and that bond yields will remain low for the foreseeable future.
How the Fed Got to This Point
Prior to the financial crisis, the management of short-term interest rates was the Fed’s primary monetary policy tool. By December 2008, however, the Federal Open Market Committee (FOMC) had already cut interest rates to zero and needed additional ammunition to boost an economy in deep recession and a stock market in free fall.
To further ease monetary policy, the Fed began its quantitative easing (QE) program, which consisted of buying large quantities of U.S. Treasuries and mortgage-backed securities (MBS).
From late 2008 through October 2014, three rounds of asset purchases grew the Fed’s balance sheet to approximately $4.5 trillion USD in assets from just under $1 trillion USD prior to the crisis. Most mainstream economists and policymakers agree that maintaining such a large balance sheet is unhealthy for the economy and financial markets in the longer run, and expect the process of shrinking it to begin in the coming months.
How Balance Sheet Run-Off Will Work
The FOMC has been reluctant to make any sudden changes to its balance sheet policy since the 2013 “taper tantrum” that followed then-Fed Chair Ben Bernanke’s initial discussion of reducing bond purchases. The current consensus among FOMC members is that shrinking the balance sheet should happen passively, and not as a result of actively selling Treasuries or MBS into the market.
To accomplish this, the FOMC has established dollar caps on the amount of Treasuries and MBS that may mature, or “roll-off,” the balance sheet each month. The monthly cap on maturing Treasuries will start at $6 billion USD and gradually rise to $30 billion USD; the cap for MBS will start at $4 billion USD and will rise to $20 billion USD. However, the maturity profile of the Fed’s bond portfolio does not precisely match these rising caps, which means that the effective monthly profile for balance sheet shrinkage will not be perfectly smooth. In months when fewer bonds mature, the balance sheet will shrink more slowly and, in months when maturities exceed the caps, the Fed will reinvest the excess proceeds.
Markets have only a vague sense of when and at what balance sheet size the run-off process will end. Some estimates pin the terminal size of the Fed’s balance sheet at approximately $3.0 trillion USD to $3.5 trillion USD, but these projections rely on assumptions about several other factors. If such estimates are correct, the current maturity structure of the Fed’s portfolio suggests a passive run-off could be completed as soon as 2020.
Market Implications of Balance Sheet Run-Off
The Fed’s balance sheet expansion has played an important role in reducing U.S. bond yields since 2008. It is logical to question, therefore, to ask whether the forthcoming balance sheet reduction will have the opposite effect and contribute to a substantial rise in future bond yields. We believe that is unlikely to occur for a few key reasons:
Run-off represents a manageable portion of total Treasury issuance: The Fed’s planned monthly caps total $180 billion USD in maturing Treasuries in the first 12 months of run-off and up to $360 billion USD each year thereafter. Relative to the net issuance of Treasury bills, notes and bonds, which totaled $700 billion USD in 2016, these figures represent a meaningful but not overwhelming increase in supply or, better, demand gap to be filled. Additionally, these numbers represent the upper limit of the Fed’s caps, and not necessarily the amount of Treasuries that will ultimately roll-off the balance sheet.
The path of the U.S. federal deficit will likely be the more fundamental driver of future Treasury issuance. Current Congressional Budget Office (CBO) forecasts call for the deficit to widen moderately in the years ahead, which would suggest a greater overall increase in Treasury supply and probably a smaller marginal impact directly attributable to changes in the Fed’s balance sheet. (These estimates are subject to considerable uncertainty and could be impacted by U.S. fiscal policy. When it comes to tax reform and infrastructure spending, we have grown skeptical that a true paradigm shift is just around the corner.)
Other sources of Treasury demand are likely to remain in place: Further, the Fed has been an important, but not the dominant, buyer of Treasuries since the financial crisis. Other market participants, including the non-U.S. (both private and official) and financial sectors, have absorbed an even larger share of the increase in outstanding Treasury debt over the same time period. We believe that global demand for Treasuries will remain steady as the fundamental drivers of that demand remain in place.
In conclusion, we believe that bond yields are likely to remain steady for now, and that the Fed’s approaching balance sheet reduction program is unlikely to disrupt the U.S. Treasury market. As always, we continue to monitor the evolving economic environment, and stand ready to adjust our asset allocation in response to material changes in inflation, fiscal policy expectations and the business cycle.
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