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How will the Fed shrink its balance sheet?

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The baseline scenario… At a stage when the Fed’s rate hike expectation is now priced at exactly these levels, what they will do about the balance sheet is a matter of curiosity. In the original scenario, a balance sheet that had grown after the Fed ended its bond purchases would have to shrink unless paid-up Treasury bonds and MBSs could be reinvested. We are evaluating the steps the Fed will take beyond automatic balance sheet contraction.

 

The overall framework of the balance sheet reduction… In February 2020, on the eve of the COVID-19 pandemic, the Fed’s balance sheet was approximately $4.2 trillion. The Fed bought trillions of dollars worth of Treasury bonds and MBS to provide monetary policy stimulus to the economy and curb deteriorating financial markets. It also provided substantial additional support and liquidity through repurchase agreements, swaps with foreign central banks, and non-traditional asset purchases/loans to businesses and municipalities. As a result, the Fed’s balance sheet has grown to nearly $9 trillion today.

 

Fed balance sheet asset structure… Source: Federal Reserve, Bloomberg

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The asset side of the Fed’s balance sheet is predominantly composed of Treasury securities and mortgage-backed securities (MBS), while the liabilities side consists mainly of money in circulation, bank reserves held at the Fed, and the general account used by the US Treasury. By the time many of the Fed’s non-traditional loans, such as central bank swaps and corporate bond purchases, that occurred early in the pandemic wore off, it had actually lowered the central bank’s balance sheet. However, the Fed’s Treasury securities and MBS holdings are still extremely high and, in fact, still growing as bond purchases are not finalized until mid-March.

 

When the Fed cut its balance sheet in 2017, it stopped reinvesting in Treasury securities and MBS up to a monthly limit. Plus; With the Fed shrinking its balance sheet, there has been upward pressure on short-term interest rates throughout 2018. The Fed therefore began modestly boosting its balance sheet again, this time by buying Treasury bills, as a way to increase bank reserves and put downward pressure on short-term interest rates. However, inflation back then was much lower than it is today. Afterwards, it had to go to an aggressive growth due to the pandemic.

 

We expect the Fed to stop reinvesting maturing securities up to a monthly cap, as the Federal Reserve did the last time it shrunk its holdings. The Fed will be open-ended in the balance sheet reduction, so we are not at a stage at this stage to reveal the extent of the asset reduction and its full impact on interest rates. Liabilities directed against the asset side of the balance sheet also require a harmony between liquidity, reserve and collateral. Otherwise, there may be a repo crisis and difficulties in controlling short-term interest rates. The Fed’s new fixed repo facility, established in July 2021, that allows banks to borrow reserves and collateralize the loan with Treasury securities, will encourage banks to hold more Treasurys and fewer reserves than when the Fed’s balance sheet was last done. Of course, the MBS side is also important. Mortgage rates will also need to be checked in terms of housing market conditions, so we will see both UST and MBS reductions on the QT side. The Fed may need to sell assets quickly to bring the balance sheet to pre-pandemic levels.

 

Conclusion? The most likely outcome will be upward pressure on long-term Treasury yields. The final degree of asset reduction is uncertain as factors such as low potential GDP growth going forward may cause the Fed to want to revise its balance sheet strategy in the future. Plus; Of course, factors such as the Treasury borrowing structure and requirement, the Fed’s reserves and the asset/liability management of banks are also important. The period from June to August seems to be suitable for the first round of balance sheet reduction. The second round announcement by the Fed in setting the upper limit may come in the period after October 2022. Yellen period tapering will be a process that will progress faster than the 2017 model balance sheet reduction.

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