Minutes from the most recent Federal Reserve (Fed) meeting, released last Wednesday, sparked selling of stocks and bonds, as investors read that the Fed may reduce its $4.2 trillion balance sheet. Minutes also revealed that “some Fed officials viewed equity prices as quite high relative to standard valuation measures” and that there are “downside risks” if “financial markets were to experience a significant correction.” As we mentioned last week, we believe the stock market reaction to the Fed minutes was overdone, but nevertheless, investors should take the ending of Fed accommodation seriously.
We do not believe that balance sheet normalization (reduction) will lead to a stock or bond market sell-off. In fact, we view this similarly to the ending of a quantitative easing (QE) period. Recently, after the Fed halted bond purchases, Treasury prices moved higher and yields lower. For example, in March 2010 after the Fed announced the end of the first phase of QE (QE1), the yield on the 10-year Treasury was 3.83% at month end. By October 2010, the yield was below 2.40%; similarly when QE2 ended in June 2011, the yield on the 10-year fell from 3.16% to below 2% by August of that year. We are not suggesting this big of a move in the Treasury market is forthcoming, only that directionally, we would expect high-quality bonds to be well supported.
Stocks have benefited since the buying program began in 2008, and to some extent there has been positive correlation (similar movement) between the S&P 500 Index and the Fed balance sheet [Figure 1]. As the balance sheet grew, stocks performed better, although the impact of earnings growth—the key fundamental driver of stock prices—makes it difficult to determine the role of the growing balance sheet. Importantly, the Fed has been clear that they do not want to disrupt markets. Their strategy to reduce the balance sheet begins with communicating policy changes in a clear and timely fashion. The terms “gradual” and “deliberate” were used in the March minutes, and because of this advanced signaling, we think the short-term risk to the stock market is muted. That said, the Fed is serious about reducing the portfolio, so additional analysis is warranted. A thorough look at how the portfolio was built, why the Fed wants to reduce it, and the composition of the holdings can help us to better understand the risks associated with unwinding a portfolio this large.
HOW DID WE GET HERE?
In order to decrease supply in the market and push interest rates lower, the Fed has purchased more than $4.2 trillion of bonds ($2.46 trillion in Treasury notes and $1.75 trillion in mortgagebacked securities) since 2008 through multiple QE programs. Although the latest QE program in the U.S. ended more than two years ago (October 2014), these holdings, known as the Fed’s balance sheet, have remained stable. The Fed has rolled proceeds from maturing bonds into new purchases, keeping the size of the Fed’s balance sheet relatively constant over the past few years, and also likely keeping rates slightly lower than they otherwise would be.
WHY REDUCE THE BALANCE SHEET?
Prior to the crisis in 2008, banks typically borrowed from the Fed to satisfy reserve requirements or to obtain financing. When the Fed began purchasing bonds on a large scale, they credited the account of the commercial bank that sold the securities. As the portfolio grew and rates moved higher, the Fed’s interest costs increased as well. For example, according to the Fed’s 2016 financial statement, they paid banks approximately $12 billion in interest during that year, twice the payment made in 2015. By reducing the balance sheet, the Fed is hoping that they can reduce interest costs and better control short-term rates.
WHAT IS IN THE PORTFOLIO?
The portfolio consists of various maturity dates, with the majority of holdings within the 1–5 year maturity bucket [Figure 2]. Since we expect the Fed to let maturities roll off rather than sell assets outright, the maturity profile is important. With only $153 billion in bonds maturing this year, the size is not enough to materially impact bond prices. However, the runoff becomes larger after 2018, with $1.2 trillion maturing between 2018 and 2022. These are primarily Treasury bonds, not mortgage-backed securities (MBS). When a Treasury bond matures, there is a payment made from the Treasury department to the Fed, and the Fed then reduces its assets and liabilities. After paying the Fed, the Treasury can issue new securities to replenish its reserve balances. This process likely adds Treasury supply to the market, which could decrease prices; however we think that the Treasury would favor issuing in the less expensive T-bills market (shorter-maturity Treasuries) if interest rates are higher. With regards to MBS, the impact may take longer to feel. This is because over 99% of the $1.7 trillion in MBS on the Fed’s balance sheet will mature in more than 10 years. That said, there is potential for mortgage borrowers to pay down their loans early (refinancing, home sales, or even just additional payments), meaning the impact could be felt sooner…