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4 things to Know About Fed Balance Sheet Runoff

The Federal Reserve (Fed) has stated that it would like to get its nearly $9 trillion balance sheet back down closer to 20% of GDP (its currently closer to 40%) so it has announced a plan to start to reduce the amount it currently reinvests, starting in June. Colloquially named quantitative tightening (QT), balance sheet runoff is another tool the Fed plans to use to help arrest stubbornly high consumer price increases. Following are four things to know about QT.

  1. The Fed plans to shrink its balance sheet by slowing reinvestment first. Currently, as bonds mature, the Fed reinvests those proceeds back into Treasury or mortgage securities. However, the Fed plans to forgo some amount of reinvestment and allow the bonds to mature and not replace them. As seen in the LPL Chart of the Day, the Fed is capping monthly runoff at $47.5 billion — $30 billion for Treasuries and $17.5 billion for mortgage-backed securities (MBS) — until September. Those thresholds will then double to a combined $95 billion a month. Analysis by Bloomberg indicates that the Fed could see its balance sheet shrink by $2.5 billion by 2024.

View enlarged chart.

“While the exact impact on financial market conditions is unknown we do not expect any near term disruptions to markets,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “The Fed is committed to going slow, but as the process plays out over time, we do think the cumulative impact could be meaningful, especially if the Fed goes too far. However, there is still an abundant amount of liquidity in the financial system that needs to be removed before credit creation conditions deteriorate, which could take several years, in our view.”

  1. The Fed will not sell securities, at least initially. As mentioned, the Fed plans to let securities organically roll off its balance sheet. The maturity of the Fed’s Treasury holdings are relatively short with over a $1 trillion set to mature in one year thus likely eliminating the need to sell securities. The MBS holdings are mostly long-dated but “mature” early through prepayments. With mortgage rates increasing recently, though, this will likely slow prepayments. In the near term there should be enough securities maturing without the need for outright sales of MBS. If the Fed wants to transition back to holding only Treasury securities though the Fed could conceivably sell MBS—an option outlined in the Fed March meeting minutes but only “after balance sheet runoff was well underway.”
  2. QT technically started on June 1 but the first tranche of Treasury securities won’t actually mature until June 15 when nearly $15 billion is set to mature. An additional $33 billion is set to mature at the end of June. As such, $48 billion of Treasury securities are set to mature during the month and the Fed will reinvest only $18 billion of Treasury bonds—the other $30 billion will be removed from the Fed’s balance sheet. The planned amount of reinvestment in MBS that is anticipated for each monthly period will be announced on or around the ninth business day of the month and will generally be conducted over the subsequent one-month period until the next announcement.
  3. The Fed has stated that QT will run in the background in tandem with interest rate hikes. However, the Fed has also mentioned that it plans to monitor the impact QT is having on markets. If it is deemed to be too restrictive to financial conditions, the Fed can moderate the amount of bonds removed from its balance sheet. Also, and importantly, the Fed has stated that QT could replace several rate hikes as a way to tighten financial conditions. Markets have already repriced an aggressive rate hiking campaign, so as the QT process plays out over time, we could conceivably see a lower Fed funds terminal rate than what is already priced in to markets, which should help the Fed navigate a “softish” landing.

 

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This entry was posted on Tuesday, June 7th, 2022 at 12:50 pm. Both comments and pings are currently closed.

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