Investors fret as Fed moves to shrink balance sheet

 

The Federal Reserve has begun sketching plans to shrink the size of its balance sheet, which ballooned during the pandemic as it vacuumed up government bonds to avert economic collapse.

The US central bank now holds just under $9tn of assets, more than double the amount in early 2020 when it embarked on an unlimited bond-buying programme to prop up markets and lower long-term borrowing costs for struggling businesses and households.

Minutes from the Fed’s policy meeting in December, which were released last week, revealed policymakers had their most comprehensive discussion yet on how they intend to manage the process.

The minutes, which also showed officials thought the Fed might need to raise interest rates “at a faster pace”, has since triggered sharp moves in financial markets as investors become more attuned to the central bank’s abrupt switch to a tighter monetary policy.

This week, real yields — derived from Treasury securities adjusted for inflation — surged to their highest level since June. Real yields affect every corner of financial markets and factor into account equations investors use to value assets from stocks to real estate.

Why is the Fed discussing this now?

Under pressure to respond to soaring inflation, the Fed had announced plans to withdraw the $120bn-a-month bond-buying programme it put in place at the onset of the pandemic.

The central bank expects to cease 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 pencilling in three quarter-point rises this year and a further five before the end of 2024.

Shrinking the balance sheet would be another way of curtailing the amount of stimulus the Fed is pumping into the economy.

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

What are its plans for reducing it?

The Fed has not made a final decision on shrinking its balance sheet, but the December meeting showed there is broad support for a relatively rapid reduction after the first interest rate rise. The process should be swifter than the Fed’s previous attempt to pare back its holdings in 2017, which had swollen after the global financial crisis in 2008.

Then, the Fed waited about two years after the first post-crisis rate rise before it stopped reinvesting the proceeds from maturing Treasuries and agency mortgage-backed securities, a process known as “run-off”. The Fed thinks it can move more quickly now thanks to “a stronger economic outlook, higher inflation and a larger balance sheet”.

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

Indeed, Fed officials support monthly caps to limit how quickly run-off can proceed to ensure a pace that is “measured and predictable”, according to the minutes. Some also back a swifter reduction of the Fed’s holdings of agency MBS faster than its Treasuries.

For now, at least, Fed officials seem to be exclusively focused on shrinking the balance sheet by not replacing bonds that mature and do not appear to be discussing selling assets outright.

Why are markets on edge?

Although the Fed had announced the end of its bond-buying programme and telegraphed looming rate rises, the discussion of its balance sheet caught investors off-guard. The last time the central bank attempted to cut its balance sheet, it ended in upheaval.

In 2019, two years after it had begun to wind down its Treasury portfolio, short-term funding costs skyrocketed. Banks, which had partially filled the gap by buying Treasuries, were less willing to lend cash to overnight borrowing facilities, further exacerbating the situation.

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

Investors are not concerned about an outright repeat of the repo crisis, but whenever the Fed withdraws stimulus, it can have unintended consequences.

The Fed has left a big imprint in the $22tn US Treasury market. As it acquired US government debt during the pandemic, it became one of the largest owners of Treasury inflation-protected securities, or Tips, depressing the yields deep into negative territory.

It owns more than a fifth of the $1.7tn of debt. If it begins to sell those bonds, the supply of Tips is expected to balloon, pushing their yields — known as real yields — up. That could reverberate in every corner of financial markets.

Investors got their first glimpse of that last week, when real yields surged, triggering a sell-off in speculative tech shares. The move, which accelerated yesterday, weighed on risky assets, with a Nasdaq fall taking its decline from a record high in November to 10 per cent.

Could it affect Treasury liquidity?

The primary block to a rapid cut in the balance sheet is the resiliency of the Treasury market when its biggest buyer starts pulling back.

The Fed put new tools in place to mitigate potential problems, including a permanent facility that allows eligible market participants to swap Treasuries and other ultra-safe securities for cash at a set rate. This is intended to avoid the volatility seen during the last attempt to shrink the balance sheet.

‘It is becoming hard to justify why the Fed is keeping such a large balance sheet’