The Federal Open Market Committee is expected to begin the process of reducing the Fed’s balance sheet. Here’s what it may mean for investors.
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Following the financial crisis, the Federal Reserve purchased bonds as a way to stimulate the economy. Then Fed Chair Ben Bernanke explained the intent of this policy, known as quantitative easing, in 2010:
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.” 1
But the Fed is now ready for a return to more normal monetary policy. At the Federal Open Market Committee (FOMC) meeting in June 2017, the Fed announced a strategy to reduce the size of its balance sheet by letting the bonds mature, a process called balance sheet normalization. And at a subsequent meeting in July, the Fed said it plans to begin this process relatively soon. Given the recent commentary from Fed officials, we expect this process to kick off at the September FOMC meeting.
It remains to be seen how this change will affect markets. Patrick Harker, president of the Federal Reserve Bank of Philadelphia, described it as the policy equivalent of watching paint dry.2 But we suspect that the effect it could have on markets may not be so boring.
The Fed grew its balance sheet by purchasing primarily U.S. Treasury bonds and mortgage-backed securities. Now, it plans for its balance sheet to decline at a rate no faster than $50 billion per month. This equates to a decline of $600 billion per year.
Growth and projected decline of the Fed’s balance sheet
Source: Federal Reserve and Columbia Threadneedle Investments as of June 30, 2017.
But what does this mean? To understand the effects this change has on the bond market, it’s helpful to translate the $600 billion annual decline in balance sheet assets into interest rate terms. When short-term interest rates reached zero in 2008, researchers at the Federal Reserve constructed a so-called shadow rate that translated bond purchases into interest rate equivalent units.3 The Fed purchased $2.2 trillion in assets from 2009 through 2014, and research indicates that the shadow rate reached -2.81% by the time asset purchases were completed in September 2014. In other words, purchasing these assets had the same effect on markets as if they had lowered interest rates by 2.81%.
To take the analysis a step further, the Fed’s planned balance sheet decline of $600 billion would be equivalent to an increase in the Fed funds rate of 0.76% or about three hikes of a quarter-point (0.25%). Every year.
The effects are likely to be uneven across markets:
- Longer maturity U.S. Treasuries may be most at risk, particularly if supply begins to increase just as the Fed is exiting the market.
- Corporate bonds may fare better for now given strong demand from overseas. However, foreign central banks are a wildcard for the corporate market if they follow the Fed and return to normal monetary policy.
- Mortgage-backed securities (MBS) sit in the crosshairs of the Fed’s plan, but may actually be better positioned than some expect. Investors are being rewarded for taking risks in MBS more so than other sectors, and over the past five years the volume of MBS bonds has increased by less than 3% per year. This could be good news: people selling MBS won’t need to try too much harder to find new buyers to take the place of the Fed.
The Fed is hopeful that its balance sheet normalization plan can run on autopilot, but whether this will occur without disruption remains to be seen. The asset purchase plan was adjusted many times post-crisis, altering the size, timing, maturity and pace of asset purchases along the way. As the economy progresses, it’s likely that the asset reduction plan may have to be tweaked as well.
1 Bernanke, Ben, “What the Fed did and why: supporting the recovery and sustaining price stability,” Washington Post, 11/04/10
2 Harker, Patrick, “Economic Outlook: The Labor Market, Rates, and the Balance Sheet.” Market News International Connect Roundtable, 05/23/17
3 Wu, Jing Cynthia and Xia, Fan Dora, “Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound,” Chicago Booth Research Paper No. 13-77, 05/18/15
Article by Gene Tannuzzo, CFA – Columbia Threadneedle Investments