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Shrinking the Feds Balance Sheet


Viking
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As the Fed continues to increase interest rates we will likely see more speculation regarding plans to shrink its balance sheet. Quantitative easing proved to be a huge benefit for financial assets (bonds and stocks). As the Fed shrinks its balance sheet will this be negative for financial markets?

 

https://www.brookings.edu/blog/ben-bernanke/2017/01/26/shrinking-the-feds-balance-sheet/

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That Bernanke piece is really good and touches on a lot of interesting points.

 

I've done some research on this for work and happy to share some of the findings.

 

Disclaimer: this is completely uncharted territory and involves a lot of guestimation, hence take my comments on the effects with a grain of salt.

 

The Fed's b/s ballooned from 800bn to 4.5tn due to quantitative easing, and is now composed of 2.4tn of Treasuries (with varying maturities) and 1.6tn of Agency Mortgage Backed Securities (the rest is in other assets like gold and repurchase agreements). In other words, the Fed owns 15% of the Tsy market and ONE THIRD of the MBS market. They are indeed a big player in both.

 

We've already seen specific comments from the Fed in terms of how they plan to start unwinding this and when from the latest minutes. Their intentions are for this process to be "gradual, passive and predictable" meaning 1) it will take a number of years to prevent market turbulence 2) they will not sell any assets but rather let the monthly maturities runoff by implementing monthly caps on the amounts that will not be reinvested and increase the cap every quarter 3) they want the market to understand this process well and have no surprises. The process is expected to start this year, my guess is in Q4.

 

The biggest question is what does a normal balance sheet look like? We know it's not going to go back to pre-crisis levels because the Fed's main liabilities have changed drastically, these are mainly currency in circulation (actual cash dollars lying around all over the world) and deposits held at the Fed by member banks. The latter should be the main one that will  reduced given that currency in circulation has grown 7% every year post-crisis and this demand should be satisfied. The new normal size of the balance sheet is expected to be anywhere from $2.5-3tn according to some estimates, but it still implies a major reduction.

 

The reduction is in itself a form of monetary tightening, although the Fed does not want this to be interpreted as a monetary tool, but we'll have to see what the market makes of this. On first order effects, the impact on the treasury market should not be too big, I would think it adds a couple of 10s of basis points to the 10yr rate each year or so but nothing game changing. The MBS market is another story given their size and all the supply that will have to be absorbed by the market. And the Fed is not supposed to hold mortgages so they will have to get rid of this entirely (and if prepayments slow down due to higher rates and less people refinancing, they may even sell these). Bottom line expect higher mortgage rates as a near certainty. Second order effects, much harder to predict, but there may be some implications on the high yield market and other fixed income products that trade on a spread over Treasury, but a lot of this will be driven by the flow of money leaving assets to go to other assets (so good luck trying to predict that...)

 

Also, tomorrow the Fed has a press conference after their interest rate decision (which market predicts 100% chance they will raise) and they should give more details about this.

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"Controlled detonation". I like that.

If (and that's a big if) markets start to falter, expect finger pointing.

The Fed would do all it can to escape criticism, would even try to "manage" expectations.

 

Usually, I don't spend much time on this macro stuff but some aspects are fascinating.

After all, we are going through the greatest monetary experiment of all times.

 

For those who are interested, a recent speech by Mr. J. Bullard, who has said in 2010 (7 long years ago) that he was concerned that the US could become "enmeshed" in a Japan-style deflationary outcome.

 

https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/2017/Bullard_Keio_University_26_May_2017.pdf?la=en

 

Recent deflationary trends definitely represent another conundrum that will eventually require an explanation.

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Chesko, given quantitative easing resulted in higher stock prices and lower bond yields can we assume that as the Fed does the opposite (shrinks its balance sheet) that this will result in higher bond yields and be a headwind to the stock market? Gundlach of Doubline feels yields on 10 year US Treasuries may go as high as 6% in the next 4 years and I wonder if the Fed shrinking its balance sheet is part of his thesis; he is calling for a choppy summer market with yields on 10 year treasuries moving higher in the fall and increasing to as high as 2.75% by year end (based on commentary on his conference call yesterday).

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Gundlach of Doubline feels yields on 10 year US Treasuries may go as high as 6% in the next 4 years

 

There will be a massive revaluation of many, many companies if 10-year US Treasuries are at 6% in 4-years.  Wouldn't a company like Caterpillar almost certainly go down 30-40% in that scenario? (Picking on Caterpillar because I think it is overvalued today anyway, but there would be hundreds of similar examples)

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The official announcement was made on Wednesday, the process will probably start in October. I ran some numbers and it looks like balance sheet will be reduced by 1.5 trillion from now until end of 2021 (1tn of treasuries and 500bn of MBS).

 

Not a lot to say right now other than wait for the market to see how it actually reacts to this and how the supply can be absorbed. Not a lot being priced in right now really.

 

Chesko, given quantitative easing resulted in higher stock prices and lower bond yields can we assume that as the Fed does the opposite (shrinks its balance sheet) that this will result in higher bond yields and be a headwind to the stock market? (based on commentary on his conference call yesterday).

 

Yes bond yields will be higher, stock market will be higher to predict though it depends how much higher yields go. A move from 2.20 in the 10 year treasury to 2.75-3% is not really a deal breaker for the stock market. Above 4% then a lot of things start to change in terms of the valuations of some sectors than have been called bond proxies (utilities, telecoms, even consumer staples). But I don't think the balance sheet unwind alone is going to cause the 10 year to move by that much. 75 bps at most in my opinion in four years. Remember the reduction is much less aggressive than the accumulation (QE) so the effects will be different.

 

At the end of the day the 10 year treasury yield is a barometer for market expectations of growth + inflation.

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At the end of the day the 10 year treasury yield is a barometer for market expectations of growth + inflation.

 

Maybe it isn't both anymore since the last 8 years the economy has grown at 2 and inflation has been 1.5 so more like a 3.5 10 year would make more sense.

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It really is amazing to see the change that has taken place in the past 12 months. 12 short months ago 10 year Treasuries yielded 1.5%, there was lots of pessimism regarding the economy and Fed rate hikes were considered taboo (and financial markets were laser focussed on the Fed).

 

This year the Fed has already increase rates twice. They just communicated a 3rd increase this year and three more next year and also communicated plans for QE unwind. The financial markets seem ok with everything the Fed wants to do.

 

My point is look how wrong consensus opinion was 12 months ago. We may be equally 'wrong' today and 10 year Treasuries could be yielding 3% in 12 months. It looks to me like we are at an inflexion point and the lows in bond yields is behind us. At inflexion points most people will remain stuck in the past. I like listening to Gundlach to understand where we may be going; he is not perfect but he provides lots of details so an investor can make an informed decision.

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